Real Estate

Consider the current economic environment where interest rates have recently been slowly increasing and may continue to do so in the foreseeable future. They may go down but it's unlikely. Now imagine borrowing £1,000 at 10% to buy a bond selling at a premium yielding 9% hoping that the 1% you are losing in interest payments will be offset by appreciation of the bond price in subsequent years due to what you hope will be lower future interest rates. Keep in mind that as interest rates go up, bond prices go down in order to create a higher yield to match the interest rate. Would you do it?

This is just a made up scenario that to me seems both speculative and risky. I don't think that any rational and well advised retail investor would ever do something like this. The risk reward ratio would just not be worth it. However, in my opinion this route is similar to the one which many property investors here in the UK have decided to take.

I recently heard about someone who has taken out an interest only mortgage on an "investment" property where the monthly rental income falls £25 per month short of the monthly mortgage repayments. And this is not including any capital expenditures. Not only is there is a highly leveraged position, some the bank's interest charges out of this person's own pocket just to keep the investment alive under the false premise that property prices will continue rising forever. Keep in mind there is an interest only mortgage which is not amortising the loan. As I’m told, because there is a leveraged position in the investment, any price appreciation will magnify any gains on the initial investment but I think there are two things being missed:

1. Leverage cuts both ways. Borrowing five times the deposit will see a 10% rise in the market price return a 50% return on the investment. On the flip side, a 10% drop in the investment will give a 50% drop in the investment.
   
2. Vitally, she is not receiving any productive economic benefit from this "investment". Instead she sees the speculative appreciation in the property price. Isn’t this the same as hoping to gain from trading commodities? Read more here
   

It's true that rent inflation will see the £25 monthly deficit disappear within a couple of years however this may take longer than anticipated if interest rates continue to increase. Moreover, if interest rates do continue to rise then that puts pressure on market price appreciation- the entire point of this investment.

There is nothing wrong with real estate as an investment as the old adage "safe as houses" still holds true in my opinion. However this style of "investment" is incredibly sensitive to any market down turn. The strange thing is that my colleague feels perfectly comfortable with the situation. I wonder what the feeling will be if, heaven forbid, the market slowed and declined enough to see her "investment" fall into a negative equity situation. What if prices were to stagnate for 10 years? What if there was forced sale? If one can afford to ride out any market storms then they will be OK in the long run but whether they will be wealthier for it I can not say. Without amortising the loan there is an even greater risk of seeing negative equity in the purchase.

I want to finish this post by citing one interesting comment made by Warren Buffet which went along the lines of "one of the characteristics of a price bubble is that investors start to invest in assets based on price appreciation alone and forget about the income generated by the asset". I think that pretty much sums it up.

Commodities Are Not Investments.

It's not hard to believe the strong economic case for the growth in commodity prices in the years ahead. With emerging economies like China and India coming online the world's supply of various raw materials to support their development is under pressure, hence pushing commodity prices up. I certainly see the reasoning behind it and I believe that it will happen.

However, I don't want to invest in commodities even though I believe in the story behind them. Why? Because commodities are not investments. They are links to economic production. They have no cash flows so they create no value related to any future productive enterprise. Also, as there is no possibility of any future cash flows how can I discount their value back to a present value today? Other than discounting the final cash flow when it comes time to sell there is no real value created to me as an investor that makes them difficult to value. Obviously the only real way to make money on a commodity transaction is if the price has gone up when it comes time to sell. But there is no way to really place a value on how much and how this price will occur.

Of course, this argument is not isolated to commodities. I would not class derivatives (futures, swaps, forwards, options etc, etc) and currencies as investments because, like commodities, they do not create any future value. They merely shift wealth from one side to the other. In other words, there is no win-win situation; there is only a win-lose situation where one person "wins" a pound at the expense of another person losing a pound. As an example, Stocks on the other can create wealth for all those involved. Consumers receive a marginal benefit from the products they purchase, employees receive benefit through their salary and investors receive a benefit through economic profit.

However commodities, derivatives and currencies do have their place in the area of risk managment. This was was the original motivation behind many derivative products. For an example read more here

So if the purchase of a commodity is not an investment then what is it? I can only conclude that commodity purchases are merely speculative- no matter how much research and thought go into the decision to buy (or sell). Commodity purchases can really only rely on macro economic information which is general at best and pricing information which is provided by the general sentiment of the market (which as any investor who has experienced a market correction knows this can change quickly). How can an investor have any fair degree of confidence to reasonably predict where the intrinsic value and margin of safety lies when we have nothing to quantify against?

As an someone who works at a large commodity hedge fund in London told me, the January 2007 commodity market recorrection was the most stressful periods of his life. Not a very nice way to spend a skiing holiday in France. Maybe if the nature of his "investments" were a little more like real investments then maybe he wouldn't have had as much to worry about.

Tulipmania and Mr. Market

First lets start with Mr Market, a classic investment analogy first explained in Bejamin Graham's book, The Intelligent Investor. The story goes something like this:

Imagine you own part of a business in partnership with a person named Mr. Market. Every day he tells you what your share of the business is worth and offers to buy your portion of the business or sell you an additional interest in the business. His views on the business swing from an incredible optimism to an overwhelming pessimism and anywhere in between. With this in mind the prices that he offers you gyrate as often as his moods do. When Mr Market quotes an incredibly high price, you might sell some of your stake in the business (or all of it if the price is right) whereas if the price he quotes you is low enough, you might decided to buy some of his stake (or all of it). However, any time the price is not right you don't have to do anything other than wait until he quotes you a price you are satisfied with based on your own ideas of what the business is worth.

This is such a simple explanation of the investment environment that we are in yet I wonder why so many investors fail to take this advice? Why any investor would sell a holding based on a declining stock price (i.e. stop losses) when the underlying "story" behind the investment has not really changed is hard to understand from a logical perspective. I often wonder whether this is because investors do not really understand what they are investing in and why.

However, I do understand that loss aversion and the games that it plays with your mind can get pretty intense at times. Even in the best case scenario, when there is a strong criteria driven business reason behind the investment, the thought of a declining stock price can make you want to sell. On the other hand, when there are a less than sound criteria behind an investment decision, a declining stock price can be hard to stomach.

Think about any investment where you felt there was a larger than normal element of speculation involved in the decision. When the price goes down on these speculative investments the first reaction is to SELL! The natural instinct against loss aversion starts to kick in. Without a set of real quantifiable investment criteria there is no way to measure the investment's price action against market events. Having this set of criteria will help to allow you to avoid investing based on emotions, tips, rumours and other psychological based biases. in other words, not knowing the underlying story behind a business and it's fundamentals gives an you very little psychological cushioning for seeing the investment through to the point where you realise the original reason for the investment in the first place.

To illustrate my point further, here’s a classic story about investor irrationality during the 1600s and the sad consequences for many of those involved. It kind of rings like the euphoric mania behind the internet stock bubble.

Tulipmania

Value

Value investing - the disciplined practice of buying assets that trade for less than their intrinsic value in an effort to gain from their long term performance. Intrinsic value? This could basically be defined as the current discounted value of the future cash flows of a business.

As an investment style, I think that value investing can be defined by the following:

An understanding of how markets are efficient
In reality only 50% of investors can beat the market so it is important to understand that by and large markets are "generally" efficient. By understanding and recognising irrational investor behaviours an investor can begin to understand how to succeed in stock market investing. However, it is fair to say that markets are not totally efficient as can be simply displayed by the periodic market corrections that we are all so familiar with.

An ability to invest with long term investment horizons
To paraphrase Ben Graham, "In the short run, the market is a voting machine, but in the long run it is a weighing machine." Understanding this simple principle enables an investor to ride out the stock market gyrations thrown at us by Mr Market. It is probably fair to say that in the short run the stock market is pretty efficient. However as most investors have relatively short term investment views, this opens up the gate to long term pricing inefficenies which can be found by investors who are prepared to wait for the market to catch up.

An ability to understand the intrinsic value of a business and to buy into that business at a realisable discount to that value
Being able to evaluate the real fundamental intrinsic value underpinning a business and then finding the opportunity to pay well below this value in order to own a piece of the business creates what is commonly known as a margin of safety. Think of it as buying £2 for £1. Moreover, an investor must have some way of searching for this value out of the universe of available investments. It would be far too time consuming for an investor to search through everything so there must be a way to screen stocks to narrow down this universe.

In combination I think these three elements give an investor a powerful set of "tools" in which to make investment decisions. However, I can't see how any one of these three skills is particularly effective when used in isolation. The old adage "fail to plan, plan to fail", is particularly important here. By producing some sort systematic methodology for investment an investor may more than likely satisfactory returns. Unfortunatly there is no exact science to it so in the beginning a lot of it is going to come down to trial and error.

Lean Investing

"Lean" is a theory that has revolutionised how many organisations manage their processes. The origins of lean thinking started with Toyota, the japanese auto manufacturer. During the 1940's, the company needed a way a way to cheaply manufacture cars - After the war, people did not have much money, let alone money for expensive cars. The question for Toyota was how could they keep production volumes low whilst at the same time keeping the cars as cheap as mass-produced cars?

From this dilemma emerged the ideas that formed the foundations of the Toyota Production System (TPS) that forms the basis of the lean models that we have today. The basic ideas behind being lean are simple- eliminate waste and concentrate on what works.

Toyota was able to greatly reduce lead times and cost using the TPS, while improving quality at the same time. Moreover, lean has enabled Toyota to become one of the ten largest companies in the world. It is currently as profitable as all the other car companies combined and Toyota became the world's largest car manufacturer in 2007. Lean has also been used with great success in the software development world so it is viable for more than just manufacturing cars. For a more information on the beginnings of lean see:

Wikipedia Page on the TPS
Mary Poppendieck's Articles on Lean

What has lean got to do with investing and asset management? When taking a holistic view of the investment management process, from the asset manager to the end client, lean may be an effective way to increase the profits for the portfolio manager whilst continuing to be ethical and loyal to the end client.

As a discipline and by its very nature, value investing lends itself very well to the ideas behind lean. For example the ideas of infrequent trading and portfolio concentration are both ideas that reduce the problems associated with market timing, stock selection/analysis costs, transaction costs. As an investment manager, costs equal waste so this is a natural area to address. Although simplistic, this may form the basis for possible appications of lean principles in investment management.

The Lean Investor

This blog has been started as a simple way to document and arrange my thoughts on investing whilst at the same time putting my thoughts up for public scrutiny. The main topics which will be covered are:

Value
Portfolio concentration, longer term investment horizons, margin of safety.

Small/Micro Cap Companies
Generally companies trading on London's Plus and AIM exchanges. These companies are often illiquid and perceived as risky due to their large standard deviation of returns.

Special Situations
Companies undergoing significant structural changes. For example, spin-offs, restructurings, mergers, bankruptcies, etc.

Market Inefficiencies
Pricing anomilies. The price of the asset is below what would normally be expected.

I'm afraid I won't be offering any stock tips or market commentaries as I feel a blog is not really the appropriate place for such information.