There – I said it! Negative gearing is all about losing money – it involves debt and high risk yet I’m almost certain that many readers will have never heard it described so bluntly.

 When was the last time you heard anyone point this out?  The promoters of negatively geared investment strategies (into property and/or shares for example) have much to gain from encouraging people to negatively gear so you won’t always receive the full story from parties who have a vested interest. So let’s look in detail at negative gearing: What is it? When is appropriate and what type of investors is it suitable for?

Gearing?

Gearing is a proxy term for ‘borrowing’ – it’s as simple as that.  You might sometimes see the term ‘leveraged investing’ wherein ‘leveraged’ also simply means borrowing.

Gearing, like how gears on a bicycle enable the rider to get over very steep hills, enables an investor to buy a larger investment(s) than their financial position would otherwise allow.  Similarly, like a ‘lever’ can enable the movement of large objects with much less human effort, so too does leveraged investing permit a larger investment(s) to be purchased than might otherwise be possible.

Gearing – leveraging – call it what you like but the bottom line is that involves borrowing money.

Negative?

This is where money is lost.  The negative in ‘negative gearing’ applies wherever the costs of servicing the investment such as loan interest, professional fees, investment maintenance (repairs etc.) exceed the income being generated by the investment(s).  In other words, the investor has to spend more to hold the investment than what the income received from it amounts to.

“Yes – but at least I can get a tax deduction!”

True, but as I once heard it stated quite simply: “That’s like spending a dollar to save 50 cents.”  And note that, under current Australian tax law, a deduction is permissible wherever the asset is Australian based and produces taxable income.  The deduction applies only to the amount of costs (interest etc.) which exceeds the income received from the investment.

So why would anyone ever negatively gear an investment(s)?

This is the key point – such an investment strategy only makes financial sense if there is a likelihood that the value of the investment(s) will increase over time.  And it is time which is a key determinant in whether or not a profit can actually be made from the strategy.

While waiting for the value of the investment(s) to increase, under a negatively geared investment strategy, an investor is losing money on the cash flow – i.e. the costs exceed the income less any tax deduction which might be available.  As such, the longer it takes for an investment to increase in value the higher the accumulating cash flow losses (negative).

So if asset values are being pushed higher quickly during say high economic growth or high inflation periods, the more quickly a negatively geared investment strategy becomes profitable – capital growth exceeds the losses being made on the cash flow.

Who does it suit and when is it best to do it?

Primarily negative gearing is most suitable for investors in the highest income tax bracket. This is because the tax deduction they can receive is at a higher level than someone on the lowest tax bracket, for example.  This just means they have less out of pocket costs in meeting the expenses of the strategy.

Periods of high economic growth and/or high inflation are generally more beneficial for negatively geared strategies simply because asset values increase more quickly at such times.

Note however that, for around twenty years, Australia has had quite low inflation and economic growth, despite the resources boom of recent years, is currently modest.

What’s the risk?

There’s more than one risk but suffice to say the list of risks includes: loan interest rate rises – loss of employment income required to cover the ‘out of pocket’ costs (investment costs – investment income + tax deduction = out of pocket costs) – prolonged injury or sickness of the investor (out of pocket costs) – slow investment value growth – declines in investment values – slow economic growth – low inflation – a future government might cancel the tax benefits …

Neutral? Positive?

Investors don’t have to gear negatively – it is possible in some situations to have a neutral gearing position or even a positively geared investment(s) and I’ll explain these strategies in my next blog.

Ray

 

       IMPORTANT – THIS IS NOT INVESTMENT ADVICE

This discussion is not a recommendation for readers to invest in any or all of the specific investments, or types of investments, discussed in this blog. Please do not act to make investments based in this commentary.  This is a general discussion about some aspects of investing and cannot account for all circumstances.

 

 

You could be forgiven for not knowing about it but 2012 was quite a good year for investment returns.  Goods news rarely makes its way to the top tier of news stories so there is every chance the 2012 results got past many investors.

In 2012 you would have heard or read a lot about continuing problems with European bonds and the on-again off-again debt issues for the United States government.  Those big global headlines easily gained more ‘air-time’ than returns from well-constructed Australian investment portfolios that straddled a rising domestic sharemarket with some quite notable results from some companies.

investment-portfolio-spreadsheets_0

 Smokescreen

Amid all the smokescreen of concern that seemed to constantly circumnavigate the world in 2012 were, for some investors, quite stellar returns.  In fact, investment results for 2012, generally, serve to illustrate the long-term benefits of careful, considered, investing.  The 2012 returns also illustrate the benefits of not making knee-jerk reactions with investing.

One thing remains a constant and that is, investment markets do not rise in value without turning down at some point. Excesses in economies such as household indebtedness are always, eventually, corrected as investment markets price-in the associated risks.  Sometimes this is known as ‘corrections’ – as in correcting the price of assets – and there are less frequent periods where price corrections are labeled as a ‘crash’ because of the depth of price declines.

Run for cover?

At times in 2012 and for several years before it would have been tempting for investors to simply sell-up and run for cover in cash or term deposits.  However, as interest rates declined in Australia through 2012, in order to stimulate the economy, the sharemarket responded with price increases in anticipation of at least maintenance of present growth levels.

While for example, the return for the German share market (the DAX) topped 29% compared to the Australian All Ordinaries Index’s 13.47% there remain large impediments in the Euro region as it grapples with high unemployment combined with low levels of consumer and business confidence. These fundamental economic issues dictate that Australian based investors must be careful not to over-allocate to international markets. Similarly, while the Japanese market topped 22% for 2012 that economy remains seemingly comatose with more than two decades of, at best, sluggish growth.

Way back when…

In looking at portfolio allocations to various economies, investors need to be vigilant to changing world dynamics. In the nineties there was a strong, valid, argument that international exposure for portfolios reduced the overall risk to portfolios as it provided a counter-cyclical defence. This meant that, generally speaking, economies were rarely in exact synchronisation and so a slow down in the Australian economy (and market returns) could be offset by growth available in other parts of the world.

In the nineties the international components of portfolios also received a ‘free-kick’ because the Australian Dollar was, on average, declining against major world currencies. This ‘tailwind’ increased the value of the international component in Australian Dollars.

But – the Dollar’s up and the rest of the world is in sync!

However, in 2013, the Australian currency is up against all world currencies and doggedly refuses to descend and give investors a free kick in the international section of their portfolios (and boost Australian exporters’ competitiveness).  Add to this a ‘rest of the world’ economic slow-down and the case for large international allocations in portfolios is hard to justify.

So where does all this leave investors in 2013?

Last year proved that diversification delivers stability in portfolios over the long term. First hand I’ve witnessed diversified portfolios, with maximum share market exposure of approximately 50%[1] of the portfolio, deliver over 15%[2] total return (income plus growth) for 2012. Note that the All Ordinaries Index is 100% shares – it’s a share market index not a diversified portfolio with exposure to other sectors.

Will that be repeated in 2013? In short, it’s most unlikely and it could be that such portfolios revert to single digit total returns.  In the event of a major share market ‘correction’ such portfolios should better withstand the overall impact. While they too will decline, the depth of their decline should be less than the overall share market simply because, unlike the share market itself, diversified portfolios are not 100% allocated to shares.

The good news of Australian investment returns for 2012 hasn’t made it to the headlines of news bulletins and it’s unlikely to. However, you’ll more than likely hear about it next time markets decline.  In the meantime, long-term investors who have resisted the temptation to run for the cover of a 100% cash allocation, fare better both in income and long term growth.

      IMPORTANT – THIS IS NOT INVESTMENT ADVICE

This discussion is not a recommendation for readers to invest in any or all of the specific investments, or types of investments, discussed in this blog. Please do not act to make investments based in this commentary.  This is a general discussion about some aspects of investing and cannot account for all circumstances.

Readers should seek their own professional advice which can take account of their personal financial position and objectives.

[1] Note this includes Australian shares, international shares (max. 10% of portfolio), listed property and hybrid interest bearing securities.

[2] Past performance is not a guarantee of future investment portfolio returns.

Bond, Skase and Connell are names of just three of the list of high profile entrepreneurial Australians who have failed at some point in their business careers.  In Australia, the latest high-profile entrepreneur to run into financial trouble is Inverell born Nathan Tinkler who, through the good fortune of a ‘tailwind’ of inflated commodity prices and friendly lenders, in April 2012 had an estimated wealth of $1.1 billion.

nathan

Photo: Louie Douvis (Sydney Morning Herald, Business Spectator)

However, with the Australian Taxation Office being the latest creditor to seek payment of the comparatively small amount of $2.7 million in back taxes, Mr Tinkler’s wealth might have fallen to the point of him being in net debt. With his holding in Whitehaven Coal now valued at around $625 million but with estimated debts of $700 million, things are certainly tight for him.

Over the last month he has embarked on selling down much of his thoroughbred horse racing interests and has had his private jet and helicopter repossessed by financiers.  From the outset, the Achilles Heel of Tinkler’s operations was the very high levels of gearing (borrowings) and he is now in substantial financial difficulty.  There are lessons in this for every business owner; for every individual.

Firstly, much of his wealth was based on borrowed money and while, in and of itself, borrowing is not a bad thing, like many things in life too much of it is far from good.  Nathan Tinkler’s ability to borrow very large amounts has to this point been underpinned by two key planks.  Firstly, borrowings were secured by a lien (a mortgage) over his shares in Whitehaven Coal (and predecessor companies) and secondly, lenders lent against the shares on an expectation that the resources boom would continue unabated for a much longer period into the future.

With the decline in global commodity prices over the last calendar year or so, in part a response to slowing demand from China, shares in resource companies like Whitehaven Coal have been bearing considerable downward price pressure.  For all resources companies this has brought on a need to cut costs wherever possible in the face of reduced revenue from sales of commodities – witness redundancies afflicting thousands of mining workers across the nation over the last six months.

From the outside at least, the Tinkler situation appears to be a case of too much (debt) too soon.  Cash flow is ultimately the lifeblood of every business (substitute ‘salary’ for cash flow, for employees) and if it’s impeded (e.g. reduced commodity prices) then things can get grim very quickly.  With an inability to meet debt obligations because of falling revenue, it’s only a matter of time before smiling lenders start to deliver other facial expressions.

The same risks are at play for individuals. Too much debt is never a good thing and myriad risks abound to curtail loan repayment ability. Consider sickness, accident and unemployment as just three of the things that could jeopardise an individual’s capacity to meet loan repayments. Then there are issues like rising interest rate cycles which eventually send some borrowers into default on loans.

Whether or not Nathan Tinkler will be able to resurrect his business’ ascendency remains to be seen. The headwinds that confront him now seem unlikely to dissipate any time soon.

While the very essence of a successful economy is that at points along the way, people have been brave enough to be entrepreneurial and start a business, there can be failures at any time in every business cycle – in good times and bad.  Yet, thanks to sound business management, plenty do succeed.  As in nature, business evolution initially sees the strong (balance sheets) survive along with those that can adapt to a changing environment.

As you read this it’s worth remembering that the very reason you can read this online, right now, is in very large part due to the entrepreneurship of people with names like Gates and Jobs!

 

 

While we live in world seemingly full of unrelenting change, there are some things that will never change in the financial world.  For a very long time, I have maintained a set of ‘Golden Rules’ that are always relevant and good for investors to keep handy when contemplating making investments.

So let’s get started with a Golden Rule that deals with tax benefits.

1.    Tax should never be the primary reason for making an investment.

Why? (people always ask)  It’s quite simple really – taxation law is subject to change so the overriding question you should ask yourself – before investing – is:

If the government were to cancel the tax benefits associated with this investment, would I still be happy to put my money into it?

If the response is ‘No’ then that – in isolation – should be sufficient to deter you from putting your money into the investment.

 

The Australian investment landscape is littered with the carcasses of investments that were marketed to investors on the basis of tax benefits which were, at times, questionable to say the least. As I write, the collapses of more than twenty years of professional practice come flooding back.  Over the years I’ve witnessed, from the sidelines, collapses of investment schemes which involved:

  • Pine trees
  • Jojoba beans
  • Cray fish farms
  • Wild flower plantations
  • Tea tree plantations
  • Ostrich breeding
  • Oak trees
  • Cattle breeding
  • Film production

Rest assured there are more failures than recorded above.  All the schemes above were variations of a theme – investors borrowed all or part of their investment and hoped for that the forecast capital and income returns came true. In many cases it was little more than the proverbial ‘wing and a prayer’ due to the fundamental flaws in the investment structures.  Some such schemes claimed that for every $1 invested a tax deduction of $5 could be claimed.

Consider this excerpt from a 2006 report by the Australian Taxation Office:

The Senate Economics References Committee found support for the view that “the growth of a highly competitive entrepreneurial promoter market … has been the most significant driver of the growth in aggressive tax planning.”

This finding built on the Committee’s previous reports. In its Interim Report it concluded:
“ it is the view of the Committee that a large number of these schemes appeared to be designed specifically to defraud the tax system and to use ordinary taxpayers in that process. Not only have they left many taxpayers with large tax bills, but many of these schemes have ceased to exist. The Committee is of the view that few schemes represented ‘a good investment’ in the ordinary meaning of the term, and that without the ‘tax deductibility’ factor, very few would have got off the ground.”

I recall explaining to students in an adult learning program which I taught that: “If the tax office ever disallows the tax deductions (on these exotic investment schemes) people will march in the street!”  And so I was not surprised to see that in Sydney, Melbourne, Perth and Canberra, so-called ‘tax effective’ scheme investors marched in protest at the Australian Taxation Office’s early 2000s decision to disallow tax deductions on such schemes[1].

To make matters worse (for such investors), the decision was made with retrospective effect to 1992.

What appealed to such investors was, in effect, a view of getting something for nothing; the so-called ‘free-ride’ that investors sometimes believe they receive when tax deductions are on offer. Of course there is no such thing as a ‘free lunch’ and many such investors were subsequently hit by the dual impact of a failed investment followed by a retrospective disallowance of tax deductions from many years previous.  For many investors, the losses amounted to hundred of thousands of dollars.

‘Tax effective schemes’ are by no means the only area where investors focused on tax deductions can be at risk. For example while I’m a great supporter of superannuation as an investment vehicle to accumulate retirement savings, it concerns me when investors have all their investment capital in superannuation. This is because – no matter how many super funds you have – superannuation is subject to constant legislative change and such change isn’t always beneficial for investors.  While it’s a very tax efficient system through which most Australians can save for retirement, there is substantial legislation risk with it.  It is sound planning to accumulate wealth in superannuation and outside of superannuation.

So the ‘Golden Rule’ is:

1.    Tax should never be the primary reason for making an investment.

Tax should only ever be a secondary consideration.  Remember: Tax laws change.

 

 



[1] The Australian Taxation Office has previously referred to the schemes as ‘abusive tax schemes’.

Put simply shares are just a proportionate ownership of a business (a share of the business) and dividends (from the word divide) are the share owner’s ‘share’ of the profit.  Explaining the long-term benefits of share price growth is relatively easy compared to explaining what I believe is the most attractive aspect of owning a share of a business – the growing value of the profit dividend!

Here’s why it’s difficult for some people to get their head around why dividends are the big winner for long term shareholders.

Future dividends – in $ terms – should represent a higher percentage (proportion) of the original price you paid for the share.  That is, the value of a dividend from a well-run business in 2022 should be higher than it is in 2012.

Following is an example of the changing value of a dividend over time. This matrix details the full year dividends for the 2002 and 2012 financial years for Woolworths Ltd (WOW):

Divs Paid 2002 Fin Year

Share Price 30/6/02

% of 30/6/02 Share Price

Divs Paid 2012 Fin Year

Share Price 30/6/12

% of 30/6/22 Share Price

 

2012 Div as % of 2002 Price

WOW  

$0.30

$13.15

2.28%

$1.24

$26.80

4.63%

9.43%

Source: Iress Market Technology

 

Some observations:

  • The dividend has increased by around 4 times over the 10 years
  • The 30 June 2012 share price is around 2 times what it was on 30 June 2002
  • For the investor who bought WOW shares on 30 June 2002, the 2012 dividend now represents a 9.43% income return on their original investment ($1.24/$13.15 x 100)

Let’s be very clear here: not every business will produce such results and the truth is – just like in your town or suburb – from time to time businesses fail completely or fail to achieve meaningful financial growth.  You can lose some or all of your money in such businesses.  However, the point is that as an economy grows and the dollar value of profits increases over time, the dollar value of dividends – from well-run companies – rises.

Following is a chart that details five different businesses including WOW:

Divs Paid 2002 Fin Year

Share Price 30/6/02

% of 30/6/02 Share Price

Divs Paid 2012 Fin Year

Share Price 30/6/12

% of 30/6/22 Share Price

 

2012 Div as % of 2002 Price

QBE  

$0.30

$6.64

4.51%

$0.65

$13.38

4.85%

9.78%

CBA  

$1.50

$32.93

4.55%

$3.34

$53.10

6.29%

10.14%

WOW  

$0.30

$13.15

2.28%

$1.24

$26.80

4.63%

9.43%

TLS  

$0.22

$4.66

4.72%

$0.28

$3.66

7.65%

6.00%

BHP  

$0.24

$10.30

2.33%

$1.03

$31.45

3.28%

10.00%

Average:

$0.51

$13.53

3.67%

$1.30

$25.67

5.34%

9.07%

Source: Iress Market Technology

 

Legend:

 QBE                           QBE Insurance

CBA                            Commonwealth Bank of Australia

WOW                        Woolworths

TLS                            Telstra

BHP                           Broken Hill Proprietary

 

There is generally speaking a pattern of share price increases and dividend increases. For the notional average price of $13.53 on 30 June 2002 this ‘investor’ in 2012 received a dividend of $1.30 – 9.07% of the original investment.

Almost as a bonus, the investor can derive some comfort that the average share price has risen substantially.

IMPORTANT – THIS IS NOT INVESTMENT ADVICE

This discussion is not a recommendation for readers to invest in any or all of the specific investments, or types of investments, discussed in this blog. Please do not act to make investments based in this commentary.  This is a general discussion about some aspects of investing and cannot account for all circumstances.

Readers should seek their own professional advice which can take account of their personal financial position and objectives.