Why invest in equities

TO Warren Buffett, the world’s most successful stock investor, investing is about foregoing consumption now in order to have the ability to consume more at a later date. So it follows that when we invest, our aim is to buy an asset whose price will grow faster than inflation over time.

What makes the price of an asset grow? Well, when you buy it cheap, and it continues to be able to generate profits over time.

The one asset class which has demonstrated its ability to do that over the long term is equities.

Here are the numbers.

It was end-March 1990. Brothers Ah Long and Ah Su had just inherited about RM175,000 each from their father. Since both brothers already owned the roofs over their heads, the father’s instruction was that the money should be invested in things other than real estate.

Ah Long, the elder son, understands how the economy works. He knew that he needed to grow the purchasing power of his inheritance if he were to be able to send his daughter to Harvard University 20 years later. He also understood that the best way to grow his money was to invest in businesses that can generate profits over the long term. But he had no time to do research on the stocks listed on the stock market at that time. So he decided to take a diversified approach, and spread his RM175,000 equally into 33 stocks listed on the Bursa then. The stocks in his portfolio included Malaysia Airlines, British-American Tobacco, DRB-Hicom, IJM Plantations and Public Bank.

Meanwhile, the younger son Ah Su is very “risk averse”. Rather than exposing his RM175,000 to the vagaries of the markets, he decided that he’d sleep better if he just kept the money in the bank and earned the yearly interests. And that’s what he did. He kept rolling his money in the bank in one-year fixed deposits, earning the prevailing interest rates each time.

Fast forward to today. How have Ah Long and Ah Su done since then?

For a full ten years after they received their inheritance, Ah Su who put his money in fixed deposit was getting more income in interest than Ah Long did from his dividends. Ah Su’s fixed deposit was giving him an average of 7% a year between 1990 and 1999, whereas Ah Long’s portfolio only yielded less than 4% in dividends. But over time, the companies in Ah Long’s portfolio grew and they were able to pay more dividends. By 2001, the dividends from the portfolio of stocks had exceeded the interest received from the fixed deposit. (See Chart 1)

Stock portfolio

Meanwhile, because the companies have grown in size, their market values have also risen. By 2001, Ah Long’s stock portfolio, which consisted of super performers like Dutch Lady, IOI and Public Bank and laggards like Malaysia Airlines, DRB-Hicom and IGB was worth RM267,000. The portfolio was worth RM407,000 the year before in 2000. But because of the dot.com crash, the portfolio value was reduced by about 34%. Some of the individual stocks in Ah Long’s portfolio have not performed. But since he has a fairly diversified basket of stocks, on a portfolio basis, he has done well.

As for Ah Su, the amount of cash he had in the bank remained at RM175,000.

By end-March 2014, Ah Long’s portfolio had a market value of RM1.38mil. The dividends he received for the preceding 12 months amounted to RM37,500. As for Ah Su, his RM175,000 fixed deposit is still in the bank. One year fixed deposits paid about 3.15% in interest in 2013. So he received about RM5,500 in interest from the bank.

So after 24 years, Ah Long’s portfolio is close to 8 times that of Ah Su’s cash. And Ah Long is receiving about 20% of Ah Su’s cash in dividends in a year! In the last 24 years, Ah Long has received dividends amounting to some RM388,000, while Ah Su’s bank interests totalled RM208,000.

So Ah Su had kept his money safe. But has he? The fact is, he has been losing purchasing power – to the tune of 50% in the past 24 years! (See Chart 2)

Because of inflation, which according to World Bank averaged about 2.8% a year in Malaysia in the past 24 years, his RM175,000 today has a purchasing power equivalent to only RM90,000 back in 1980. His RM5,500 interest today is equivalent to RM2,800 of the money back in 1980.

Here’s one clear example of how severe the loss of purchasing power can be. Not too long ago, you can get a three-room terrace house in Penang for slightly over RM200,000. Today, without some RM1mil, no seller would even talk to you.

Ah Long, after 24 years of being invested in equities, is in a better financial state. After adjusting for inflation, his portfolio is worth 4 times in terms of purchasing power relative to the RM175,000 he was given back in 1990. Had he reinvested all the dividends he received throughout the years back into the market, his portfolio would have been worth even more today. But of course, we all need to strike a balance between living today and in saving for the future.

So if we agree that investing is about delaying consumption today so that we can have the capacity to consume more at a later date, then the risk of investment is the probability of the loss of our purchasing power over the investment period. Given the data presented above, holding cash is indisputably more risky than holding equities!

Since we started with Buffett, let’s end with him as well. In October 2008, when the world was reeling from the global financial crisis, the Sage of Omaha told The New York Times: “Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.”

Today, just five years on, the Dow is above 16,000 points. Shun equities at your own peril!

Teh Hooi Ling was a multi-award winning investment columnist in Singapore who is now a partner in Aggregate Asset Management, manager of a no-management fee Asia value fund.