Relative Value -- Part Two

In my last article I looked at the relative value of gold vs. the other precious metals.  In this article I would like to explore the concept of relative value in a larger variety of investment contexts.

As I have done on occasions before, I am performing a "Thought Experiment" (actually a few), many of these topics I have looked at in a somewhat cursory manner, but they do illustrate the points I am trying to make, that there is value in examining "relative value".

Before I get into specific examples, I would like to make some comments on relative value in general.  First, this term "relative value" can be a little slippery to define well, in each case here I will try to point out properties or circumstances that might be unique in what I am examining,

Second, much of this is subjective, hard for me to say "this is fact"...  I personally believe that this subjectivity pervades almost all of these comparisons, and comparing relative values is the bulk of what I will examine here now.

Third, because of the subjectivity, and also because of uncertainty in general (and of course the possibility that I may read some things wrongly), I continue to believe that diversification is the best and smartest thing that most investors can do, unless they are extremely talented or extremely connected.

While I think the above notions of definition, subjectivity and uncertainty (and I will refer back to them various times) need to be kept in mind as we explore these topics, I think there has been enough navel-gazing, so let's get going...!

***

I recently (three or so days ago) a nice comment on Greece vs. South Korea.  Alas, I do not remember where I saw the comment, but it was a great comment!  My words, also expanding on the comment:

"What does South Korea export?  Cars, electronic chips, cell phones, ships and quality bearings [OK, I added that last one].  What does Greece export?   ...   ...   ...  Ah!  Greek yogurt (although much "Greek" yogurt is US-made), cheap wine, and olive oil."

That (original) comment stuck with me over these days, and was the creative spark for this article.  But, as I did some research, I found that a South Korea vs. Greece comparison was not so good, very unfair to Greece.  South Korea has 50 million people, Greece but 11 million.  But I could not find a single European country that really was reasonably comparable to South Korea (population, GDP / capita, etc.).  Spain comes kind of close, but not close enough for me.

So, this being a Thought Experiment, I will make up a country!  (Please note that subjectivity and uncertainty mentioned above now come into play, these concepts matter, even in the context of a "Thought Experiment")  Actually this made-up country might very well be easy to visualize: Itaña!  Which is my little hybrid of Spain and Italy.  I know, I know, purists are going to hate and/or attack this methodology, but this is for illustration and thought...  Both countries are reasonably similar to each other, both share some characteristcs with Korea, let's define "Itaña" as the average population, GDP / capita and certain other characteristics of two countries (info from wikipedia):

Similarities
			Natural	Destroyed in	GDP /
Country	History	Population	Resources	Recent Wars?	Capita
South Korea	impressive history	50,000,000	not much	very much	$33k
"Itaña"	VERY impressive history	53,000,000	not much	yes, but less so	$30k

(South Korea DOES have an impressive history, they even invented their own alphabet in the 1400s, "Hangul" (한국어), and while alien-looking, the written language is phonetic, more so than English...)

So, in some ways these two "countries" are roughly equal by some objective measures.  South Korea and "Itaña" both have great food too, yum...  ("Itaña", however, IS more geared up for Western tourists, with more to see.)

Now let's do some comparisons (differences):

South Korea

-- Exports cars (flagship Hyundai, the ONLY car company Toyota worries about)
-- Exports lots bearings of high quality (I wish their capacity was higher!)
-- Exports cutting-edge electronics
-- Bearing factories extremely modern (inc. robots, see my May 2012 articles)
-- Capital city Seoul as free Wifi everywhere, including outside
-- Children bust their asses in school, consistently perform near the top worldwide
-- Many work 60 hours per week (that is what I saw, see my May 2012 articles)

"Itaña"

-- Exports some cars, but...
-- Exports some bearings, but not nearly as many as Korea
-- No significant high-tech exports I know of...
-- Bearing factories are old & "Dickensian"
-- Capital cities do not have free Wifi in most places, most hotels & Starbucks do though
-- I don't know how well their children are educated, "probably" similar to ours...
-- They do not work 60 hours in Italy and Spain...

Which "country" adds the most value to the world's GDP (put aside cultural matters greatly favoring Italy and Spain)?  South Korea.

Conclusion: by this analysis South Korea has higher "Relative Value" to the world's GDP.  South Korea is probably even more "green than Italy & Spain as well, so there!  :-p

***

Stocks and bonds have been compared so often to each other that some discussion of these two asset classes is almost required in an article like this.

Long ago, stocks often had high dividends to support stock prices, because their earnings were so volatile that without the inducement of high dividend yields, investors often would not hold them.  Some fifty years ago, this tradition died out to a large degree.  Dividend yields went down as investors preferred to bet on the rise in stock prices ("appreciation", which typically was higher than bond yields) as well as allowing the companies to better invest those funds for the future (instead of handing over the cash to shareholders).  Gains in share prices were (and are) typically taxed at a lower Capital Gains tax rate, an additional reason for companies to keep dividends low.

Bonds in the meantime then went on to become better yield investments, with both a higher yield and somewhat better security of payment.  Bonds were more suitable for those in retirement, as retirees could count on a fairly certain income stream.  Inflation came in the 1970s and caused a lot of pain for bond owners (as interest rates went up, then-current bond holders lost out as the value of bonds went down), but for some, the interest rate declines int he 1980s made them a LOT of money (my cousin did very well loading up on Treasury Bonds when their rates were in the mid-teens).

How about now?  Mmm...  All I see is danger everywhere!  Maybe some opportunity too (the old saying is, after all, "Buy when blood is running in the streets!").  Entry back into recession is very possible (perhaps we never left the 2008 - 2009 Great Recession).  QE-to-Infinity is likely, but there is talk of a "taper", where the Fed may cut back on their $85 billion / month bond-buying program...  Would the taper destroy the stock market?  Would QE666 destroy bonds and the dollar?  We now enter the playground of subjectivity and uncertainty mentioned near the beginning of this article.

My guesses?  Bonds look to me to be extremely dangerous.  By historical standards bond rates are still very low.  Even though rates have moved up a fair percentage amount at the long end (and hence much money has been LOST, anyone reading THAT anywhere???), we are still well below historical norms on, say, the 10-Year Treasury (now at some 2.83% plus or minus).  But, stock prices in the coming near and medium term future are quite uncertain IMO..., lots of risk of BAD earnings if the chips fall badly for the economy...

My verdict of stocks vs. bonds?  Stocks NOW probably offer a bit more Relative Value than bonds.

***

We own an interesting pair of investments that can be compared to a degree as well.  And they both pay us about the same amount of income (for a few more years anyway).

Our company in Peru, Ameru Trading del Peru S.A., owes us money which they are paying down like they would pay a mortgage.  We receive 5%, which is perfectly OK with me (and our tax accountant is OK with the structure of this).  That 5% is secured by the whole company, of which my wife and I own the bulk.  So, we get 5% on the outstanding loan amount for several more years (that interest can go up if 10-Year yields go up, that is in our loan documentation).  But, once that loan has been paid off, well no more income (at least from the loan, maybe I will ask to be paid then!).  And we own (most of) a profitable debt-free Peruvian company.  This is a bit like a Private Capital investment.  But, the investment is in Peru...

We also own a small commercial rental property in a smallish Southern city (not here where I live).  The rent is pretty comparable to the amount we get from Peru each year.  We collect rent from two tenants, but the "quality" of the leases is not so high (a "high quality tenant" would be a solid large company like a CVS with a 30 year lease, etc., my tenants are not THAT good: shorter lease and a small company).  And of course we own the property (well it is in a trust for the family, but still...).  OK, so we own a property that throws off an income and could be sold.  Yet, this property is not as valuable as one that threw off the same rent (the "CVS" example) as a higher quality tenant is worth more -- more certainty!

Which of these investments has a higher "Relative Value", assuming things like the value of the assets (company in Peru vs. real estate in the southern USA) were also similar like the incomes are?  I do not know without having to do more work and make more subjective judgements...  In this case, we'll keep them both, diversification...

***

Diversification brings me to my last example of comparing Relative Value.  This one may put me on a "Hate List" or two as well (LOL...).  And that is "All Inn Gold" vs. "Broad Diversification".  I will use equations from probability to illustrate my idea of which is higher, even though subjectivity and uncertainty raise their ugly heads again...  I am going to use equations from probability of expectation, which is kind of averaging a guess based on return expectations vs. risks.  And, I will not know the results of what I am about to do until they are done!  Oh, how exciting (I LOVE probability, as long as I can understand it...), let's get started!  We will start with All Inn Gold, easier calculations first!

(Actually, I know of only ONE person who is All Inn Gold, but that doesn't matter for the purposes of this analysis, FWIW, this is important to understand, it takes guts (IMO) to do this)

All Inn Gold

Let's make some assumptions (subjectivity...), hey look, I am just "MSU" as I go along, this is a "Thought Experiment" here!:

-- probability of Freegold to $55,000 per oz: 25%
-- probability of Freegold to $25,000 per oz: 25%
-- probability of Freegold to $85,000 per oz 10%
-- probability of gold staying around, say, $1400: 20%
-- probability of gold falling to, say, $900: 20%

(all numbers, above and below, are inflation adjusted, "let's say" a five year time horizon)

The expected value of our gold (per oz) would be calculated using the following equation, where E is the expected value of X (gold) , x (the $ values just above) and p(x) (the probabilities of each value above):

E[X] = SUM xp(x)

	x ($)	p(x)	xp(x)
	$55,000	0.25	$13,750
	$25,000	0.25	$6,250
	$85,000	0.10	$8,500
	$1,400	0.20	$280
	$900	0.20	$180
Expected Gold Price:			$28,960

That would work out to some 21 times current price (now about $1370) or 2100%!  FOFOA's best guess (admittedly his "best guess" because who can know?) is a 30 to 40 times current price rise.

Note that this assumes a pretty high probability of Freegold happening more-or-less as he foresees...  If we assume that a Freegold event is of lower probability, or set of probabilities, that lowers (perhaps dramatically) the expected value of gold.  Subjectivity and uncertainty...

Broad Diversification

These calculations could get way out of hand even in a simple Thought Experiment like this, so I will pretty radically simplify for illustration.  Let's say the below asset percentages, probabilities of performance, expected prices for each are "fairly realistic: and let's go from there (remember, five years):

Real estate in USA and company in Peru appreciation: x = 25%, p(x) = 40%
Real estate in USA and company in Peru appreciation: x = 10%, p(x) = 20%
Real estate in USA and company in Peru appreciation: x = 40%, p(x) = 20%
Real estate in USA and company in Peru appreciation: x =   0%, p(x) = 20%
Income stream from real estate and Peruvian company: x = 40%, p(x) = 100%

(Above are 50% of portfolio)

Gold appreciation, net expected value as calculated above: 2100%

(Gold is 10% of portfolio)

Diversified stocks, appreciation: x = 40%, p(x) = 50%
Diversified stocks, appreciation: x = 30%, p(x) = 25%
Diversified stocks, appreciation: x = 10%, p(x) = 25%
Income stream from stocks: x = 10%, p(x) = 100%

(Stocks are 40% of portfolio)

OK,...

	x	p(x)	% portfolio	xp(x)(% po)
US R.E. and Peruvian Co.	0.25	0.40	50%	0.05
US R.E. and Peruvian Co.	0.10	0.20	50%	0.01
US R.E. and Peruvian Co.	0.40	0.20	50%	0.04
US R.E. and Peruvian Co.	0.00	0.20	50%	0
US R.E. and Peruvian Co. (income)	0.40	1.00	50%	0.2
Gold	21.00	1.00	10%	2.1
Stocks	0.40	0.50	40%	0.08
Stocks	0.30	0.25	40%	0.03
Stocks	0.10	0.20	40%	0.008
Stocks (income)	0.10	1.00	40%	0.04
Expected Growth:				2.558

Expected growth of above portfolio would equal 2.558 * 100% = 255%.  Most of that would be from the 10% in gold...  Not very much from all the other investments (call it 45% over five years or about 8% per year -- a pretty normal mainstream number).

Conclusion:

OK, if you are pretty sure that gold will have the big reset, you do not mind running this risks of miscalculation, and your wife will let you do it (!), the above numbers say (the math) that the All Inn Gold is the way to go!  But, here is how I would think this through:

1. Gold, fishez!  Yes, according to the arithmetic above, the "Relative Value" at the All Inn Gold is higher.  Expected return is some 2100% over five years for "All Inn", that's great!  But, concentration of risk as well as the subjectivity and uncertainty risks are very high...  And this, dear readers, is too scary for me.
2. If you are NOT SURE, then play it safe, hold 10% in gold, you would get some 255% over five years, which is not that bad, it works out to some 18% or so per year.  That's not enough to get rich, but it's not bad!  And lower risk...
3. The numbers also show that gold really ought to be a part of everyone's portfolio!  Diversification into gold will not only protect you from a SHTF (to some degree anyway, call it "insurance"), but would allow a BIG gain at low risk if FOFOA and Freegolders are right!

Ahh, you may be wondering about p(FOFOA's numbers) -- the probability of FOFOA being mostly correct!  That is the big question...  One that I have no solid idea about...  Do I think it likely?  Yes, I do.  How likely?  Hmm.  Not enough to bet the ranch on it!  

Your comments are very welcome!

Please do not use this "Thought Experiment" to construct your own personal financial portfolio, this for your imagination and educational purposes only...