I am on a lot of real estate, economics, and investing distribution lists. A lot. Some of them are high quality, some aren’t so great. Some of them are aligned with my philosophies, others are not. But the reason for all of them is to learn. I am not sure how I got on the distribution list of Investment Management Associates (IMA), written by its CEO Vitaliy Katsenelson, but I am glad that I did. While IMA invests only in tradable securities and would not seem to be relevant to the world of real estate investing, I have appreciated Vitaliy’s clear headed manner of communicating his broader investment thesis, and his occasional outlooks on life. With acknowledgement of the possibility of confirmation bias (because I often find myself in agreement with Vitaliy’s thoughts), I still find value in how his thoughts are gathered, outlined, and communicated. With Vitaliy’s permission, below is his most recent investor letter. If you enjoy Vitaliy’s writing as much I do, you can subscribe to IMAs distribution list by clicking here. If you would like more information about their investing and track record you can visit their website: imausa.com. At the end of this Insight, I add a few comments of my own to bring this back to real estate and the current investing environment.
__________________________________________________
The Magnificent 7 and the Dangers of Market Hype
You can also listen to a professional narration of this article on iTunes & online
Despite the S&P 500 showing gains in the mid-teens, the average stock on the market is either up slightly or flat for the year. Most of the gains in the index came from the Magnificent 7 stocks, which constitute 35% of the index! The equal-weighted index, where the Mag 7 have only a 1.4% weight, is up only about 4% this year (as of this writing).
The Magnificent 7 are starting to look like the Nifty Fifty stocks from the 1970s (Kodak, Polaroid, Avon, Xerox, and others) – stocks you “had to own” or you were left behind – until all your gains were taken away or you faced a decade or two of no returns. Forty years later, it’s easy to dismiss these companies as has-beens. They’ve all either gone bankrupt or become irrelevant. But back then, they were the stars of corporate America, just like the Magnificent 7 are today.
As an investor, it’s crucial to know which games you play and which ones you don’t. Let me explain.
For every company we own, we build a financial model; make reasonable projections of revenues, margins etc. for decades into the future, estimate and then discount cash flows (bring them to today’s dollars). Finally, we aim to buy the company at a discount (margin of safety) to whatever range of fair values the model spits out. Magnificent 7 stocks require us to draw straight lines with cash flows growing at significantly elevated rates far into the future, and even then, we get values yielding either mediocre or negative returns – forget about any margin of safety.
Their valuation demands a perfect, highly prosperous vision of the future with little competition and insatiable demand for whatever they produce. Though these are truly terrific companies, which dominate their industries, and have track records of success and growth, the financial history of markets is not on their side. Their valuation reflects only optimism and nothing else. In all fairness, I am discussing these seven stocks as a monolith, and they are not. For instance, Nvidia’s valuation is a lot more demanding (it is a very expensive stock) than Google’s (which is less expensive), and so on.
The reason I am zooming in on these stocks is because they are “the market” today, or at least a huge part of it. When you hear or read about “the market” being up or down at any specific point, this is usually a reference to the S&P 500 (SPY) market-capitalization-weighted index. If you look at the equal-weighted cousin of the S&P 500, the RSP, it has underperformed SPY by 27% since January 2023.
Don’t get me wrong, the average stock in these indices is expensive. We have a hard time finding new stocks to buy, and we have been looking nonstop (most opportunities have come outside of the US). But most of the action and price appreciation that has driven “the market” has happened in those seven oh-so-magnificent stocks.
The majority of people who are buying these stocks today are not thinking about cash flows decades into the future. They’re thinking, will these companies beat estimates over the next six months? What happens to their earnings (they don’t even pay attention to cash flows) past this short time frame is irrelevant; it’s not part of that game.
We don’t play this game for several reasons. Let’s be honest – we’re not good at it. It would be like a marathon runner trying to compete in a 100-meter race. It’s endurance vs. quickness. We focus on the endurance (survival) strategy.
Also, if people are honest with themselves, most are horrible at that quick game. You’re looking for a greater fool to buy an overvalued asset. When the market runs out of greater fools, as it always does, the punishment is equally quick, and it’s severe.
A Small Hedge
We put in a small hedge (in accounts where we had option authorization) by buying puts on the S&P 500 (SPY). These instruments appreciate in price when the market declines. Think of it as minimal insurance with a 10-15% deductible that will expire on January 17, 2025. I wrote about option hedging in the past; you can read about it here.
The question comes to mind: Why not hedge the full portfolio? Answer: because that’s very expensive, despite options being relatively cheap today. There is a well-known investor I respect who had horrendous returns over the last 20 years (his fund is down 50%) because he ran a fully hedged portfolio.
This hedge is not supposed to “save” the portfolio if the market declines, but to provide a tiny buffer and cash infusion if/when “the market” significantly cracks. Our biggest hedge is our carefully constructed portfolio (of high-quality, undervalued businesses) itself.
__________________________________________________
As most Insight readers know, Altus is deep into the efforts of our new Altus Opportunity Fund, both in sourcing investment dollars, and also placing those dollars in investments we love. This is after several years of suppressed investment activity, with the last couple years of almost no new investment activity at all. Cap rates are the inverse of PE ratios, and just as the S&P is expensive from a historical perspective (and very expensive in the popular sectors), real estate was highly expensive over the past several years (and even more so in popular areas like multifamily repositioning). That has changed. I wouldn’t say the broader investment real estate market is necessarily cheap, but it is far more affordable that it has been. And as valuations come down (meaning the value of each new dollar of investment goes up), there are considerably more “companies to buy” at prices we find highly attractive. Does this mean the market won’t go down further? Of course not. Does this mean there may not be even better deals next year? We hope there are. But if we can put a property through a model such as Vitaliy discussed and it provides close to a no loss type of output, how we can not proceed?
One such example is an industrial building we recently purchased at $12/sf in a market with little vacancy. That doesn’t include any allocation of purchase price to several acres of laydown yard or additional land for future development. In many places $12/sf is below the cost of the permits and impact fees. Yes, the property needs some work (less than $2/sf), and yes, it isn’t a super nice class A building, and yes, it is empty. But there is almost nowhere for the price to move downward, as only a small part of the property needs to be leased for it to provide a nice investment return. Once it is leased and the market stabilizes, we will still own a property that was purchased for $12/sf. What is it worth when that day comes? And when will that day come? We don’t know for sure, but $40/sf sure doesn’t seem out of line. Two years? Three years? Even if we call it five years…do the math it and isn’t hard to see the value.
True hedging is harder to do in real estate than in the public markets, so our hedging – which we will define here as risk mitigation against unforeseen circumstances – is a little different than buying puts on the SPY. And real estate is in a far different place in the valuation cycle than stocks. But the thinking and mindset around hedging remains vital to any investment philosophy. The Opportunity Fund does so by investing in debt. The debt produces lower returns than the equity investors are expected to return, but it also provides more dependable cash flow and increased liquidity during a time when the real estate markets are feeling a liquidity squeeze more broadly. As equity investments like the industrial property referenced above stabilize and begin to provide cash flow, and as the real estate market stabilizes and returns to “normal”, we can rotate out of the debt position and into higher returning investments.
There are many different investing philosophies that can be considered. Generally speaking, different philosophies are less about what is right or wrong, and far more about where our own thinking and world paradigm lies. It is important for investors to be aligned with the philosophies of their investment vehicles, and it is important for companies like us that work with lots of investors, and to strive to have investors that have aligned investment philosophies to our own, at least for the portion of their investment portfolio that is invested in Altus projects.
Happy Investing.
