Owning Real Assets - Equities

Introduction to Asset Ownership

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In our previous discussion, we explored the two principal avenues to wealth-building: lending money or owning assets. Having delved deep into the intricacies of lending, we now turn our attention to the path of asset ownership.

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Assets can broadly be classified into two types:

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1. Natural yielding / income-producing assets: This category includes properties, private equity, public equity, and more.
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2. Non-yielding assets: This category spans both perishable and non-perishable assets, such as gold, diamonds, art, baseball cards, Bitcoin, and more.

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When focusing on wealth management, it's evident that the most effective long-term strategy is to concentrate on income-producing assets. These assets guarantee a regular stream of returns for the investor, ensuring the asset remains in demand due to its inherent income-generating nature.

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The asset that most people feel comfortable with is real estate. For generations, in both developing and developed markets, the conviction has been deeply embedded that real estate is the primary route to wealth management. Let's illustrate this with an example.

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Understanding Equities with an Example

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Nadia, throughout her career, has managed to save a considerable amount of money. She now wants to invest in something that will generate a steady income stream while preserving its value against inflation. Nadia chooses to invest in a property in Downtown Dubai, which is rented out and generates a 7% annual return after considering maintenance and other costs. As time passes, Nadia decides to invest further. She buys a second property, this time in Saadiyat in Abu Dhabi, diversifying her portfolio and yielding the same net return. Over the years, Nadia sells her business for a substantial sum and continues her property investments, further diversifying even internationally. Let's now say she owns 100 properties; it's unrealistic to assume she can manage these independently, so she hires a team for legal assistance, rent collection, maintenance, refurbishment, and so on. This decision reduces her net rental income to 6%. Essentially, Nadia now owns a property investment company, a private entity unlisted on an exchange. She can sell this company or, as another option, take it public, transforming it into an exchange-traded real estate company (known technically as a REIT).

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This journey illustrates that property ownership is a subset of equity, a crucial term to understand in greater detail. 'Equity' fundamentally refers to the ownership of for-profit companies, i.e. income-producing assets.

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At present, REITs contribute to 4% of the entire equity market. However, real estate constitutes much more than just that—think about how many of the world's properties are owned by companies, including cloud centers, retail, popular tourist attractions, et cetera.

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Now let’s consider another illustrative scenario: An individual decides to invest their savings in a large amount of wheat, intending to store it securely. However, as wheat is perishable, this wouldn't be a savvy investment strategy. Imagine instead that the same individual decides to buy a plot of land and employs a team to cultivate wheat on this land annually, which can then be sold. Essentially, the expected annual income stream for this individual depends on the market value of wheat. This scenario mirrors the workings of a company like ADM. Your entitlement as an owner isn't to a predetermined fixed dollar earning; rather, it's tied to the profitability derived from the demand for the goods or services produced.

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Thus, equity essentially encapsulates the concept of owning the elements of production—the intrinsic value creation in the process.

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The driving force behind all businesses or equities is profitability; the pursuit of economic gain is their fundamental purpose. In periods where profit eludes them, management instinctively tightens the purse strings, lowering expenditures to claw back into the green. There are, of course, strategic exceptions to this norm. On occasion, a leadership team might tolerate an anticipated loss as a calculated gamble to seize greater market share, their eyes on the larger prize of enhanced profitability in the future.

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In essence, equity signifies ownership in a company, and with ownership comes a claim on profits. As a shareholder, you hold a slice of the company's profitability, irrespective of whether that slice is a sliver or a substantial chunk. This entitlement to profits directly aligns with the size of your ownership stake. So, in the world of equity, your share is indeed proportional to your share.

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Inflation and Diversification

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Let's imagine, for a moment, that you hold shares in Unilever. As of June 20th, 2023, the math suggests that every $100 invested in the company yielded an earning of $6.25 over the past twelve months. If Unilever maintains this profitability level year after year, your return as an investor hovers steadily around 6.25%. Yet, the landscape of business is seldom consistent and typically requires adjustment for a couple of key variables. Firstly, with the ever-present specter of inflation, Unilever's operating costs are bound to increase. Fortunately, they can also adjust their product pricing to counteract this, which means profitability - or earnings - are concurrently climbing with inflation. Secondly, if you were to engage in a candid conversation with Unilever's executive management, they'd share insights into their multifaceted strategic initiatives designed to spur further growth in profitability. Over the last three years, their strategic efforts have fostered an annualized net income increase of 10.75%, inclusive of inflation. So, when you're invested in Unilever, your anticipated earnings extend beyond just the previous year's profitability. They also encompass a growth rate fueled by strategic expansion and inflationary adjustments.

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The Unilever example underscores an integral principle: equity ownership inherently shields against inflation. Why? Because profitability hinges on the future price of goods or services, which naturally scale upwards with inflation. The illustration also elucidates how to calculate expected long-term returns on equities, which essentially comprise the sum of the earnings yield, growth, and inflation.

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Let's shift our focus to the unpredictable world of risk, a field where uncertainties dwell in the questions like: Can Unilever sustain its profitability? Will their goods/services keep pace with inflation? Will the management keep the company on an upward trajectory? These doubts pose challenges, and our role as wealth managers is to navigate these choppy waters. A seasoned sailor in this context employs the strategy of diversification.

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Instead of solely investing in Unilever, a savvy strategy is to spread out your investment eggs across multiple baskets—into its competitors such as Colgate-Palmolive and Procter & Gamble, and across different sectors like Consumer Discretionary (e.g., Nike), Energy (e.g., Schlumberger), Communication, and more. This strategy gives you exposure to the breadth of the global production of goods and services, as offered by the public market. Imagine if you owned a piece of the 1,500 largest companies globally. As of June 20th, 2023, their combined earnings yield over the last 12 months would stand at 5.37%. This percentage essentially represents your expected return, assuming these companies maintain the same profitability as they did in the past year. This, however, doesn't account for the growth usually seen in global company earnings due to global growth (GDP) and inflation over time.

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By casting your net wide with diversification, you bring more predictability to your expected returns and bolster the long-term preservation of your wealth.

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Here, it's worth making a note about volatility: while it may seem alarming in the short term, volatility loses its edge over longer periods, falling away to reveal the underlying strength of fundamentals. The majority of investment objectives are long-term, so when you zoom out and look at the broader picture, short-term fluctuations become less significant against the steady backdrop of consistent returns.

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Conclusion

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To sum up, we've dove into wealth-building, emphasizing asset ownership, particularly in income-generating assets like real estate and equities. We've seen, through examples like Nadia and Unilever, how these investments offer protection against inflation and promise steady, long-term returns. The importance of diversification was underscored, as it provides more predictable returns and better safeguards wealth. Finally, we touched on how short-term market volatility is less significant when viewed against the backdrop of solid business fundamentals and long-term investment goals.

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