For the first time in decades, one of the year's best-selling books is about economics. Capital in the Twenty-First Century by Thomas Piketty argues that, in a capitalist society, economic inequality is bound to increase because the growth of capital outpaces the growth in the general economy.
And yet you know that the capital of most families is dissipated over time. Some form of the expression "from shirtsleeves to shirtsleeves in three generations" exists in all developed societies.
Given Mr. Piketty's thesis that capital grows immutably, how can you ensure that your family breaks the mold and grows its capital for the long run?
You should begin by understanding that, to succeed, you must behave differently from a pension fund or any other institution that doesn't have to pay taxes.
To illustrate, let's compare the after-tax return from investing in bonds and stocks. Over the past 100 years, long-term bonds have produced an annual return averaging about 6 per cent. During this period, inflation has averaged about 3 per cent. If you're not taxable, a real (after-inflation) return of 3 per cent may be quite acceptable.
If you are a taxpayer, however, the results are not as happy. The top marginal tax rate in Canada is just under 50 per cent, and this rate is applied to your nominal (before-inflation) return. If you own bonds yielding 6 per cent, you get about 3 per cent after tax. With inflation averaging 3 per cent over the long run, your real return is zero.
How, in a free-market economy, can bonds yield no real return? The answer is that the prices (and returns) of financial assets are set by non-taxable entities, who are by far the biggest buyers and sellers of securities. Over time, the return is zero only for the minority of investors who are taxable.
Fortunately, the erosion from tax and inflation is less if you invest in stocks. History teaches us that stocks produce, over the long run, a return of about 9 per cent per annum. Let's assume that your portfolio consists of both Canadian and non-Canadian companies, with one-third of the return coming from dividends and the balance from capital gains. Let's also, for now, assume that all the stocks in your portfolio are sold and replaced with new stocks once each year.
Because you are paying tax on your capital gains each year, you will pay tax at an average rate of about 33 per cent. You will, therefore, earn about 6 per cent after accounting for the tax – or a real return of about 3 per cent annually. That may sound modest, but it sure beats the zero real return earned on bonds.
A key concept, then, is to invest in the right asset class. Even when capital gains taxes are paid annually, the value of stocks will, over time, grow at a far higher rate than bonds.
Better still, you are not obliged to sell stocks every year. The longer you hold your stocks, the longer the payment of capital gains tax will be postponed, the lower your effective tax rate and the higher your after-tax return.
On death, Canadians are obliged to pay tax on all unrealized capital gains. So, to really benefit from the after-tax compounding of your capital you must buy, hold – and live to be as old as Methuselah. Fortunately, companies don't suffer from mortality. So, some families choose to own their investments in a family holding company, thereby both increasing their after-tax return and extending their investment horizon.
Thanks to the magic of compounding, exponential growth over longer periods produces extraordinary results. An 8 per cent annual return will, over 50 years, multiply an initial investment by more than 45 times.
Now let's check our theory against the real world. If our analysis is correct, families who follow this approach – using holding companies to buy shares of one or more predictable businesses which they hold for the very long run – should be the most successful in building wealth. This is exactly how Canada's very wealthiest families have gotten that way – and more than 90 per cent of their wealth has been created in the past 35 years.
Any one of us could have, 35 years ago, bought shares of Thomson Corp. (now Thomson Reuters), George Weston or Power Corp. And, assuming we had the discipline to hang on to the investment, our percentage gain over that period would have equalled that of the principal owners.
Hindsight is, of course, always 20/20 and not all public companies have done as well. But many have. There is no shortage of companies that have been public for many decades and have produced well above average returns. Examples include Procter & Gamble Co., Johnson & Johnson, Nestlé – and the principal Canadian chartered banks. These companies are likely to produce superior returns for many years to come.
While the three-stage process of growth, maintenance and decay may be inevitable, there is no need for it to take place over three generations. All that is required is long-term planning and discipline.
R.B. (Biff) Matthews is chairman of Longview Asset Management, a Toronto-based investment management firm.