Income changes better indicate real net worth

Mr. Darcy, the proud protagonist of Jane Austen’s Pride and Prejudice, was greatly admired for having an income of “10,000 [pounds] per year.” Based on the novel and the films, he certainly seems to have had a nice lifestyle with his London townhouse and huge country estate.

But his story begs the question: Why was his wealth described in terms of his cash flow as opposed to his net worth?

It’s a difficult question to answer, so I’ll take some literary licence and assume people such as Mr. Darcy could not look up the value of their assets on the Internet daily and, as such, defined their wealth by the cash flow it generated.

Why is this important in any way?

A few weeks ago, Capgemini came out with their annual review of High Net Worth families—$1 million or more of investable assets outside of personal residence—around the world.

The report measured wealth by net worth and the value (or, more accurately, the price) of HNW families’ assets, not cash flow. It showed:

• The number of HNW families across the globe shrunk by 15%; from 10.1 million in 2007 to 8.6 million families a year later. In Canada, the numbers dropped by 24%; to 213,000 families from 281,000;
• The wealth of all of these families was reduced almost 20% from $41-trillion to $32.7-trillion;
• The number of Ultra-HNW families—$30-million or more of investable assets— dropped by an even greater 24.7% last year.
• Most asset classes lost money. Equities performed dismally—global equity markets are now worth a little less than they were in 1999 and dropped by 50% [overall] last year.
• Equities dropped from 33% of assets to 25% in 2008. However, a major chunk of this change was a result of a drop in equity prices. It’s interesting to note that a 33% equity position in 2007 is much lower than what is typically recommended in the financial services industry. A typical balanced investor would be expected to have about 60% to 70% in equities. (Our own equity models have been about 30-35% for the last 10 years.)

However, real estate increased as a percentage of assets from 14% to 18%, even as housing prices dropped and the Dow Jones Global REIT index went from a high of 1574 in February 2007 to 621 in December of 2008 (a 60% drop). This makes more sense than it first appears. As last year’s crisis unfolded, investors were eager to get to some level of safety in government bonds and cash. Real estate is relatively illiquid, but REITs are publicly traded. This means irrational investors were selling REITs as the primary method of reducing exposure to real estate. By reasonable definitions, REIT prices around the world were expensive and well above the Net Asset Value (NAV) in February 2007. However, they were well under-priced by the end of 2008 as panic selling settled in. REITs have not been this cheap in relation to NAV in more than a decade.

Stock prices are the same or a little worse than they were 10 years ago in most major markets. In addition, they have been very volatile; the S& P 500 dropped 45% between 2000 and 2002 again in 2008. The dividends paid on those same stocks, however, only dropped marginally—by less than 7% between 2000 and 2002, and not at all in 2008. (That said, it’s likely they will end up being about 20% lower by the end of 2009.)

The examples above show how the cash flow of an asset and its price (not necessarily its value) part ways. Price is the result of a daily auction where buyers and sellers try and guess the future. Cash flow, on the other hand, is primarily based on the quality of tenants (real estate), the skill of management (stocks) or the strength of the borrower (bonds and mortgages). The investor has a huge impact on price and almost no impact on cash flow.

This is perhaps the primary reason why wealth should first be defined by income (as was the case in Mr. Darcy’s time) and only secondarily by net worth. In the end, if your assets maintain or increase their cash flow, the long-term value will be undiminished and prices will at some time reflect that value.

So even though in 2008 1.5 million families saw their investable assets fall below $1million—an average drop of 20%—few would have seen any appreciable change in their cash income from these assets.

This recession is the worst since the 1930s and incomes on some assets will drop. In most cases they will recover when the recession is over. History shows, though, that during the last few hundred years, changes in the income generated by most passive assets is far less volatile than price and thus a far better indicator of real wealth.

As Oscar Wilde put it: “It is better to have a permanent income than to be fascinating.”

I’m sure a number of Jane Austen’s literary ladies would agree.

John Nicola is founding partner and financial planner at Nicola Wealth Management. He can be reached at jnicola@nicolawealth.com