Altus Insight- August, 2013
The Altus Insight
Market news, commentary and relevant topics for today’s alternative asset investor
Date: August 31, 2013
FR: Forrest Jinks
RE: Rules to Invest By
We are often asked for our opinion as to what makes for a good investor, and specifically as related to the alternative investment world. Within our team there is a healthy difference of opinion on the intricacies of this matter, but the many decades of combined alternative investment experience do agree on several key factors. Some of the following are common refrains that will be familiar to most of you. The power in the list below is not in its creativity or originality, but rather in following the rules, not just giving lip service to them. Without further ado, our top 10 list:
1. Discipline: In the iconic movie Tommy Boy, the father of Chris Farley’s character (Tommy) talks the bank into to providing a loan to his company with the line, “Why say no, when it feels so good to say yes.” The bankers agree that saying yes is easier, they supply the loan and then immediately regret it when dad falls over dead of a heart attack without a succession plan in place. The lesson for investors is that no one ever loses money on investments they don’t make. Yes, it can be argued that money WOULD have been made if the investment was made, but no principal is ever lost by saying no. The real estate bubble of the 2000s is a perfect example of this. I know many different experienced investors who pulled out of the market because they felt it was overheated, only to get caught up in the fervor of the bubble and get back into the market just in time to get clobbered. Their head was correct in saying no, but they didn't have the discipline to overcome their emotions. At Altus we review dozens, if not hundreds, of projects for each project in which we invest. There have been times we have walked away from a purchase opportunity because we were only a couple hundred dollars apart from the seller. Yes, it would drive the real estate crazy, but we have clear rules that guide our investing (see rule #3 in this article) and we stick to them. If we justify overreaching our rule for $500, is it also justifiable for $750, and if for $750, then how about for $1500, and so on. There is no doubt we sometimes leave money on the table but when we do swing, we rarely miss. Additionally, because we are disciplined in our approach, we are able to stand firm in negotiations and often secure better terms than a competitor would have in the same situation.
2. Have clear investment rules: Investment rules don’t have to be anything grand or full of detail, though they can be. Rules are used just to protect ourselves from ourselves and make sure we don’t get off target in chasing our goals or deviating from our plan (#5 in this list). Examples of an investment rule might be “I will not make any investment that drops my cash balances below 6 months reserves” or “I will only invest in businesses within 50 miles from my house” or “I only invest in assets that produce twice as much income as the debt payments”. All this isn’t to say we can’t adjust our rules over time or invest outside of our normal rule set, but when we do we need to be cognoscente that we are varying from our standards and make sure we are doing it because of a conscience decision and not because of emotion/greed. Recently Altus Equity had a project in contract that wasn’t within our normal set of rules. We were aware of this and because of it built costs into our budget to bring in outsourced experts. Additionally, we determined that we needed to have an expected profit margin quite a bit higher than our normal targeted margins to offset the risk of any unforeseen items that we might have missed in our due diligence, due to our inexperience in this particular asset type. In the end, the project looked to be quite profitable and we had the couple million dollars in investment lined up to do the project, but we decided to pass on it anyway. It simply was to far away from our sweet spot.
3. Willingness to go against “common knowledge”: Market commentators take themselves so seriously but very few have any applicable experience. Instead they are entertainers, paid not for the quality of their advice, but rather for the viewership they can attract. I am sure everyone is familiar with Jim Kramer of Mad Money, but does anyone know the track record of his recommendations or his own portfolio? “Common knowledge” says over an extended time period a person can’t outperform the market. While this is absolutely true if a person only invests in market index funds, I know unequivocally that people, especially the wealthy, are obtaining returns far stronger than the general market. When a 12% return doubles your investment 50% faster than a return only 4% lower (8%), it becomes pretty apparent the long term difference of consistently outperforming the market even if by a little. Even at a 12% versus a 10% return, $1000 turns into a $100,000 a full 8 years faster.
4. Willingness to be wrong or right on your own: Warren Buffet has been attributed to saying he wants to invest when there is blood in the streets. And this is one reason Mr. Buffett has been such an extraordinary investor for such a long length of time (and is a great example of someone out performing the “market”). Most investors, because of insecurities, are afraid to go against the market. Being wrong isn’t nearly as painful when everyone is also wrong. But it is impossible to beat the market following the market. John Paulson, a long time and decently successful hedge fund manager, was willing to buck the market in the mid 2000s and put all his chips on the table that the housing bubble would collapse. He was derided in the press and lost some major investors. As 2007 wore into 2008 he was running out of capital and had key stakeholders begging him to move off of his positions. He stuck to his guns and ended up with the most profitable trade of all time. Soon after he made major investments into financial companies. When they didn’t perform well initially he was again skewered in the financial press and often referred to as lucky in his original housing bet. His play into the financials ended up paying very well. We have experienced a little bit of a similar situation. In late 2008 the housing market was on sale, not just a single house here or there, but the entire market was full of value. Despite our best efforts and an argument for investment that no one disagreed with, finding investors willing to invest was almost impossible. The investors that we did finally get on board made a killing. Years later as the market recovery gained momentum and the press caught on, we had people we had talked to years before calling us and wanting to invest. That particular bus had already left the station and we had moved on to the next investment strategy, and that market opportunity, maybe the opportunity of a life time, had already passed. Peer pressure is an amazing force, not just for teenagers not wanting to give into their friends at a party, but for adults who don’t want to be different from their peers. Being strong enough to ignore it and consider investments on their merit, not on the hype, is a key to success.
5. Money follows management/Bet on the horse not on the jockey: Business acquisitions guru Keith Cunningham is fond of reminding people that McDonalds makes a lousy hamburger but has still sold more hamburgers than anyone in the history of the planet. There is no doubting the long term abilities of the McDonalds management team. Similarly, there is a reason why some people have Silicon Valley venture capitalist throwing money at an idea they wrote on the back of an envelope while other people with fantastic ideas can’t get a dime. The first group has a track record, the second group might, but if they do it is not a good one. Product is important, but in the long run not nearly as much so as the ability to operate around that product. If you are an investor that wants to catch a shooting star, focus on product, but if you are an investor than is focused on long term and more consistent success, focus on management.
6. Pigs get fat, hogs get slaughtered: Everyone should want as high of returns as possible for the amount of risk they are willing to take. The key in that statement is “amount of risk they are willing to take”. Expect strong returns, but don’t take on more risk than is prudent for your goals/plans/experience/etc. Chasing that extra bit of return without regard to the extra risk (being a hog) is what gets people into trouble. Another area an investor can cross the pig/hog line is in pushing the manager/principal of the investment to take to slim of a profit split. This works against the investor in two ways. First, the experienced principal is going to be much more secure in the deal they are offering pushing the “hog” to invest in a similar asset with less experienced principals that are more desperate for the money. As discussed in rule #8, experience and track record are important components of a sound investment decision. The second issue with trying to squeeze a principal is as the principals expected return becomes smaller, their human nature will push their focus to do the same. This becomes especially acute if the investment or principal hits rough economic times, further decreasing the profit incentive while they are simultaneously having their attention pulled away to other matters of survival. In regards to this second point, I should be clear that there are extraordinarily principled sponsors/principals that will do what is right without regard to compensation, but it doesn’t hold true to all of them. If you find a talented principal who also has a strong moral compass, either as an individual or as a company, you have likely found yourself a winner.
7. Know your goals and have a plan: Most people have a certain reason for investing. It might be to retire with a certain quality of life, leave a certain amount of money as inheritance for the next generation, fund a child’s college costs, or help a charity. Starting with the outcome desired, and being careful to not let assumptions get in the way of reality, we can then work backward to where we are today and determine what is needed to get from where we are to where we need to be. If a person has $1 million in the bank and figures to need $1.1 million in exactly 18 months, their investment portfolio should look very different than someone that has $200,000 and expects to need $1,000,000 in approximately ten years. The first person should have very little risk in their portfolio which is okay because they don’t need to achieve a large percentage return. However, the second person needs to secure much higher returns because they have to make up a lot of ground. Also, because their time line is approximate and longer in nature, they are better suited to ride out the volatility of markets in high growth positions.
8. Humility: What is more important, being right or being rich? Unless you are Carl Icahn or Warren Buffet, there is a better investor than you out there. This is true for all of us, but isn’t it a lot more common for someone to be bragging about their 15% return last year instead of finding someone who has a 20% return and finding out how they did it? In my experience the investors who consistently have the best success are pretty quiet about their activities and success. Humility also allows us to do honest self appraisals of our investment strategies or emotions and then comparing ourselves to more successful investors. Without understanding our shortcomings they can’t be corrected.
9. Understand the numbers: This relates to many aspects of the investment world: 1. What are the numbers for the project or business in which you are considering investing? Do they have enough cash to continue operations until they hit the expected jackpot? Is profitability increasing even while cash balances are falling? What is the market size for the products offered? Enron is a wonderful example of how important it is to understand ALL the numbers. Wall Street analysts were still touting Enron as a “buy” right up until the time the lid blew off the operations. However, students at the University of Buffalo published a research paper on Enron a couple years before showing that even while Enron’s profitability was increasing their cash receipts were falling, the combination of which was due to Enron taking riskier and riskier positions in future energy production (more information available upon request). How could college students identify the issue while Wall Street professionals were blind to it? One answer is they spent more time looking at the numbers. The second is they didn’t have the same paradigms or social pressures regarding their analysis. We will discuss the social pressures more below.
10. Understand taxes: There is no easier way to boost real net returns than understanding the implications of taxes on your investment returns. For instance, simply shifting returns between short and long term capital gains results in an increase to after federal income tax returns of 15.4%. In real numbers, this changes a 10% net return to an 11.5% return or a 15% net return to a 17.3% return. These are real numbers making a real difference. There are many more strategies that can be considered; shifting earned income to business income (save on SSI and payroll tax), investments with special tax treatment (using real estate to shift income to long term capital gains through depreciation), beneficial tax geographies, one-time tax incentives…just to name a few.
My personal experience provides a perfect anecdote for this investing rule. A friend of mine had a good year last year. I was fortunate enough to also have a good year. We ended up with a roughly equivalent amount of combined income and gains for the year but as a rough estimate my tax bill will be 1/3rd of his. Yes, he is looking for an accountant to help him with his tax strategy for next year.
Until next month,