Wednesday, October 12, 2011

The 7 Fundamentals of Sound Investment

Reprinted from the newsletter by Al Jacobs, author of Nobody's Fool: A Skeptic's Guide to Prosperity June 2011

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Over the past four decades of involvement in investments, both participating in and observing, I’ve witnessed about every variation imaginable.  During this period I’ve also surveyed endless advice and recommendations on the subject.  Yet, despite the overwhelming amount of information available, the actual principles of investment are few in number and basic in their application.  Generally, if you can cut through the maze that surrounds a proposal or offering, the elements upon which its probable success or failure relies becomes easily observed.  To this end, I’d like to discuss the seven fundamental factors that govern investment.

1.  Consider your Comfort Level.  Whatever your selected endeavor, take into consideration your personal abilities and limitations.  If, for example, you function well with people in a down-to-earth business setting and enjoy the challenge of making repairs and improvements to real property, you might be a natural in owning and managing apartment units.  However, if you consider the prospect of tenant interaction repugnant, and regard property maintenance as a drag, you’ll do yourself no favor by entering that field.  Similarly, if you find a corporation’s annual report intriguing, and eagerly scrutinize analysts’ reviews in the evaluation of public companies (there really are such people), you could find success in building and maintaining an active and profitable securities portfolio.  But for those of you who regard corporate securities a bore, or for whom ownership of a share of stock that declines in value causes mental anguish, you’re probably better off staying clear of the market.

2.  Beware of Needless Complexity.  Mounted in a frame on my wall is one of the many versions of Murphy’s Law.  It reads: “Nothing is as easy as it looks.  Everything takes longer than you expect.  And if anything can go wrong—it will, at the worst possible moment.”  That pretty well spells it out; as matters become increasingly complex, there are more things to go wrong.  Therefore, if you choose to purchase subordinated debentures issued by a firm that manufactures and markets highly specialized golf clubs, the safety of your investment will be subject to successful management of the company, competition by other firms, the popularity of golf, and many other variables I can’t even imagine.  By contrast, when loaning money to a homeowner with good credit and substantial home equity, secured by a mortgage on that property, there is far less uncertainty.  As the prevailing theory goes, reward increases with risk, so that you’d expect interest paid on that debenture to be far greater than on the mortgage loan.  But in real life it doesn’t always work that way.  It’s for this reason that in every case, it’s your job to consider the complexities, analyze the risk, and decide whether the return is adequate.

3.  Be Certain the Numbers Make Sense.  When presented with an investment proposal, together with a set of figures that purports to show how advantageous it will be, the first thing to consider is whether the numbers are reasonable.  Do they seem to make sense?  I’ll give you an actual example.  I recently analyzed the purchase of an annual 1-week interval at a timeshareproject for a friend, the specific property being a 750 sq ft, 2-bedroom condominium in an outlying resort area in Southern California.  The terms: $14,500 price, 20% down payment, monthly mortgage installments $97.90 for 15 years, and $47.50 monthly toward taxes, insurance, maintenance, and supervision.  Although my friend could easily afford the $2,900 down and $1,745 a year carrying cost, I pointed out that an identical unit at the resort rented at a daily rate of $125.  Why purchase if the cost of a week’s stay is only $903, with no initial investment or mortgage burden?  To conclude my argument I quickly calculated that, with buyers for each of the year’s 52 weeks obtained under the same terms, thetimeshare association receives $754,000 in sales revenue plus $29,640 in annual payments for that single unit.  Adding insult to injury, similarly sized condominiums a few miles away garnered a market price of only $195,000.  As you might guess, my friend expressed no further interest in the project.

4.  Identify the Source of Profitability.  If anything constitutes the heart of an investment, it’s the reasonable assurance that it will generate a benefit of some sort over a defined period of time.  In the case of corporate stock, this is the systematic payment of a dividend and/or appreciation in share value.  For the ownership of commercial real estate, it means an expectation the property will generate a net cash flow as well as experience some value enhancement.  Note that the basis for value is not the benefit generated, but rather the “reasonable assurance” of this benefit.  This may seem illogical, but it’s significant.  In each case, value is determined by careful analysis of the underlying operations.  To make the point, even though it may pay its holder a fortune, a lottery ticket possesses no definable value.  There can be no reasonable assurance that it will deliver anything.  And yet it is this gambling mentality that often takes charge in establishing whole industries.  As a striking example, consider America’s technology firms in the years leading up to their 2000 collapse.  Many of those companies experienced phenomenal increases in common stock price despite the fact they neither generated income, produced viable products, nor offered future promise.  No reasonably anticipated benefits existed; any value relied on pure speculation.  By contrast, as I began purchasing previously foreclosed-upon condominiums in 1995 from banks and government agencies in then-bankrupt Orange County, California, the rental market assured an annual 16% return on the less-than-replacement-cost purchase prices.  Whether or not the properties might one day appreciate in value seemed almost unimportant.  The predictable cash return justified any long term risk.  It worked nicely and the six-fold increase in market value over the following ten years, almost an afterthought, proved to be massive frosting on the cake.

5.  Verify the Information.  Though you obviously realize it’s unwise to make an investment without verifying all the pertinent details, this is more easily said than done.  One case in point is the selecting of corporate securities.  You’re familiar with the information that firms such as Value Line and Standard & Poor’s provide when advising on the soundness of a company.  However, you can’t ignore the fact that shortly before Enron Corporation filed in Chapter 11 Bankruptcy, all the rating services gave the company’s stock a high grade.  Similarly, the mutual-fund monitoring service, Morningstar, evaluates funds on the basis of risk and performance.  Nonetheless, when in the autumn of 2003, many of the funds experienced a melt-down amidst revelations of fraud, Morningstar provided no advance warnings.  If these professional evaluators found themselves so easily fooled, what are your chances?  Of course, there’s no pat answer to that question.  Each of us must recognize our own limitations.  One response is to hedge our bet with diversity.  Thus, instead of heavy investment in each of only a few stocks, we’ll spread our choices to minimize the risk if one or two of them go sour.  One prominent radio advisor urges no more than four percent of a person’s portfolio be placed in any one security.  A second technique, and one I favor, is to avoid the sort of investments that require reliance on either company reports or rating services.  It means that in examining an operation, sufficient details that can be understood and relied upon must be available from independent sources.  Above all, each element of the information must be clear enough that it can be corroborated by common sense.  This is the approach of one very successful investor, Warren Buffet, Chairman of Berkshire Hathaway, who escaped the collapse of technology stocks in 2000.  He explained that he abstained from investing in that sector because he did not understand it.

6.  Arrange for Adequate Security.  I’ll repeat the admonition of Murphy’s Law, “If anything can go wrong—it will,” following it with the Boy Scout motto: “Be prepared.”  It’s always advisable if you can cover downside risk with some sort of security.  There’s no better example of this principle than in the lending business.  The difference between unsecured debt, such as a signature loan, and an obligation that’s secured by a mortgage—a document that permits the lender to seize a parcel of property by foreclosure—can mean the difference between wipeout and full recompense.  To hew the line even more cautiously, we might further distinguish between mortgage loans secured by owner-occupied single family homes versus those secured by apartment houses.  In the event of loan default in the former instance, the owners may avail themselves of various delaying tactics including prolonged bankruptcy action.  If the home equity securing the loan is inadequate, the lender may suffer.  But with an apartment loan in many judicial districts, the courts will often award receivership, permitting the lender to commandeer the building and collect the rents during the foreclosure period.  It is this option that can make the difference between loss and gain.  It goes without saying, of course, that the more clearly you understand the details of an endeavor, the better you are able to prepare for what might go wrong.

7.  Search Carefully for any Overriding Defect.  The last thing to do before making a financial commitment is to step back and view it for any element that seriously detracts from its viability.  Is there some specific defect that might nullify an otherwise inviting opportunity?  As an example, I’ll offer a testimonial.  In 1993, at the depth of a Southern California real estate recession—admittedly far less disastrous than the depression we are suffering here in 2011—I encountered an opportunity to purchase a 38-unit apartment building in Riverside County.  The owner, a bank that acquired it in a prior foreclosure, wanted to unload.  From my perspective, almost everything seemed ideal.  With only six units occupied, and those by evictable deadbeats, I intended to secure tenancy of my choice.  Despite its abysmal physical condition, other buildings in that locale looked pretty good.  And best of all, the bank offered to make a 95% loan-to-facilitate at a purchase price of only three times the building’s annual potential rent schedule—virtually a “steal.”  As I said, everything seemed ideal—almost.  There was, however, one fly in the ointment: A partner came with the property.  For reasons I never fully understood, the bank seemed bound to a commitment that a former holder of interest retain an undivided fifty percent beneficial ownership interest with whoever should purchase the property.  Thus, I would be only half-owner, with all the limitations that might entail.  To make a long and traumatic story very short, I met the prospective partner, ordered a credit check, and ran a five-county judicial search on him.  His record proved to be as bad as I perceived him.  For that reason, although the property offered the potential of quadrupling in value over a four year period, I reluctantly passed up the purchase.  I’ve never regretted my decision, though I do shudder somewhat when I think back at the lost opportunity.

Let me sum things up.  Successful investment can be challenging, but need not be overwhelming.  Apply these seven fundamentals to each investment opportunity you encounter and you’ll quickly eliminate those with fatal flaws.  But keep in mind that you’ll not be popular with whoever is advocating your participation.  It’s unhappily true that most investments are promoted by interested parties who exaggerate benefits and minimize risks.  My advice: Ignore the pitch and rely on your own analysis.  And remember always that if it doesn’t make sense to you, it doesn’t make sense.

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