Alan Hull Articles

Asset Management - Part 2

If we are investing in companies, then our perception is that we own part of the company as an asset. The purpose of our assets is to produce passive income, which means that we don't have to work for it. The way that companies produce income for us is by paying an annual dividend, a share of the profits. We may also have the bonus of tax credits, in the event that the company has already paid some or all of the tax owing on the profits which are paid out to us as dividends. Commonwealth Bank of Australia is a good example of a public company as an income producing asset. If you had bought shares in CBA around the time of their initial listing, in the second half of 1991, you would have paid approximately $6.50 per share and 10 years on you would have been receiving an annual dividend payment of at least $1.30 per share. That's a very respectable 20% annual return on your original investment. Assets mature over time and CBA shares have matured very quickly thanks to the primarily bullish nature of the last couple of decades. Let's now examine the current share price by looking at a price chart.

We can see that during this 6 month period, the value of CBA shares has fallen by approximately 5%. But, since we own the company as an income producing asset, the current share price is of little relevance to us. We are only interested in the dividend as a percentage of the price we paid for the shares. The current share price is only important to us if we wish to sell our shares. If we choose to sell our CBA shares then we will incur Capital Gains Tax. (and lose an income source) That's why it doesn't pay to sell assets. To realize any capital growth on the share price we can borrow against the equity. If you borrow against the equity then you won't have to pay capital gains tax and if you use the borrowing's for further investment purposes then you will receive a tax deduction on the interest repayments. This is one of the tricks of the wealthy. When the banks lend money against the value of shares, it's called margin lending. The best way to understand margin lending is to look at some examples.

Example 1
• Assume that you bought $10,000 worth of CBA shares at $6.50 each in 1991
• By 2001 the share price is $29.50 and your CBA shares are now worth $45,385
• The bank will loan you up to 70% of the value of your CBA shares.
  Tip - Only borrow against 66% of your holdings (0.66 x 45,385 = $30,000)
  By only borrowing against 66% of your holdings you will avoid a margin call in the event of the share price suffering a significant fall.
• You can borrow 70% (the margin for CBA shares) of $30,000 which equals $21,000
• You don't pay tax on the $21,000 because it's money that you've borrowed
• You can use your dividends to pay off the loan because you still own the shares

You can use the $21,000 for any purpose including buying more shares. If you use the $21,000 to buy more shares, then you are leveraging your existing assets. Leveraging has been the central theme at every wealth creation seminar that I've ever attended whether it was based on property or stockmarket investment. Whilst the concept of leveraging and gearing is totally valid it is often used as a marketing tool, in conjunction with home equity, to promote dubious investments. Unfortunately, people can become so blinded by the opportunity of owning 100 acres of land that they take the agent's spiel at face value. Often it turns out to be a swamp and the only likely tenants are native water fowl. Always evaluate an investment on its merits and worry about how you're going to pay for it, if and when, you decide to acquire it. One of the best ways to put the equity in our CBA shares to work is to buy more CBA shares just after a stockmarket crash. The mathematics of margin lending is slightly different in this application.

Example 2
• Assume that CBA shares have dropped to $20 each in a crash
• Your CBA shares are now worth $30,769 and you want to buy more CBA shares
• The bank will loan you up to 70% of your entire holdings in CBA shares
• Therefore you can borrow $70,000 from the bank to take your holdings to $100,000
• Only borrow 66% of $70,000 ($46,200) to avoid a margin call if the share price drops.

You will now receive the dividends for your entire holdings -($30,769 + $46,200 = $76,969)
The loan interest is tax deductible because you are using it for investment purposes.

The annual dividends are driven by the performance of the company and a stockmarket crash will have no direct impact on their value. You are only concerned with what the CBA Bank is worth in terms of real assets and its income producing capabilities and not what an irrational stockmarket values it at during a period of mass panic.

We want to accumulate assets... not buy and sell them. The teachings of Warren Buffet become extremely relevant when it comes to investing in public companies. We won't go into great detail on how to value public companies but here are several points worth summarizing.

These points cover property investment as well as investing in public companies. Bearing in mind that Warren Buffet has the financial wherewithal to control the public companies that he buys and we don't, we must be very careful when choosing companies that will last us a lifetime.

You can see how this single criteria rules out high technology stocks given the volatility of their operating environment. This is why Warren Buffet has a strong preference for companies that provide essential products and services such as toilet paper manufacturers, etc.

Investing in either public companies or property could just as easily be referred to as asset management and good asset managers are anything but passive. Asset management falls under the heading of active investing and the vast majority of people own assets of some type that require management. In the next article we will look at setting specific benchmarks for the purpose of seeking out 'Lifetime, income-producing Assets'.

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