"It was the best of times, it was the worst of times..."
This is, of course, the famous opening line to Charles Dickens' classic, A Tale of Two Cities. The same words can be said of the investment environment from the perspective of a true value investor. We often get puzzled looks from our family and friends when asked for our current market outlook. We are often optimistic when the news is bad and are often cautious or downright pessimistic when the news is good. When we explain the value philosophy to our family and friends, some get it and some don't. If you are a value investor and find yourself struggling to explain this to folks, here's how we do it.
Whether we are buying stocks, bonds, real estate, private businesses, cars, microwaves, or a pair of shoes, we want to get the most value for our dollar. This means getting the highest quality (or highest return) relative to the amount spent (or invested).
Most people understand real estate, so we often use that as an example. Let's assume we are going to buy a residential rental property and pay cash. What do we want? We want the highest monthly cash flow with the least number of problems. We would typically eliminate neighborhoods with high crime rates, high unemployment and low quality tenants. So we search in middle-class neighborhoods near jobs and schools where we can expect a steady flow of hard-working families.
Let's assume that we are looking in the Central Valley of California. There are good neighborhoods, is typically a good job market, is strong demand due to the favorable climate and one can occasionally find some attractive deals due to the high number of foreclosures.
Now let's assume we can find a 1200 square foot home with three bedrooms and two bathrooms near schools and parks. Now let's assume that a cash buyer can buy the property for $150,000 and rent it out for $1100 per month. Is that a good deal? Most people can do simple back-of-the-envelope math and figure that $1100 x 12 months per year is $13,200 in gross annual rent. Then we subtract $2200 for property taxes and insurance. That leaves us with $11,000 per year, assuming we have no vacancies and no major repairs (generous assumptions). So if we pay $150,000 for the property, we expect to receive a 7.3% yield on our investment. Most people would say that is a reasonably good return and would not be swayed much by the ups and downs in housing prices because it is a "long-term investment."
For some reason that very simple logic is completely lost when it comes to stocks and bonds. We tell our family and friends to think about stocks and bonds in the same way they would think about real estate. Let's look to some parallel questions to see the similarities. Is it a good neighborhood? Is it a good industry? Is the tenant's income stable? Are the profits of the business stable? Does the tenant have too much debt? Does the business have too much debt? Can we trust the tenant to take care of the property? Can we trust management to take care of the company? What is the cap rate of the property? What is the free cash flow yield of the business? Are we getting a good return considering the risks involved? The last question applies to all investments.
Is a 7.3% cap rate a good return considering the time and effort required to be a landlord? Is it a good return considering the risk of vacancies, major repairs and the illiquidity of real estate? Is an equivalent cash flow yield a good return considering the risks of being a passive, minority owner of a publicly traded company? Is it a good return considering the sometimes violent price swings in the stock market?
We find great yields in bear markets, panics and crashes. And we are often unenthused or pessimistic about yields in bull markets. In other words, our outlook often runs contrary to popular sentiment. This is why we get puzzled looks from family and friends. The average person typically thinks only about recent price trends, completely ignoring underlying values or yields. Depending on how you look at things, a bull market or bear market can be the best of times, it can be the worst of times.
For more insight and investment research, visit us at IgnoreTheMarket.com.
This is, of course, the famous opening line to Charles Dickens' classic, A Tale of Two Cities. The same words can be said of the investment environment from the perspective of a true value investor. We often get puzzled looks from our family and friends when asked for our current market outlook. We are often optimistic when the news is bad and are often cautious or downright pessimistic when the news is good. When we explain the value philosophy to our family and friends, some get it and some don't. If you are a value investor and find yourself struggling to explain this to folks, here's how we do it.
Whether we are buying stocks, bonds, real estate, private businesses, cars, microwaves, or a pair of shoes, we want to get the most value for our dollar. This means getting the highest quality (or highest return) relative to the amount spent (or invested).
Most people understand real estate, so we often use that as an example. Let's assume we are going to buy a residential rental property and pay cash. What do we want? We want the highest monthly cash flow with the least number of problems. We would typically eliminate neighborhoods with high crime rates, high unemployment and low quality tenants. So we search in middle-class neighborhoods near jobs and schools where we can expect a steady flow of hard-working families.
Let's assume that we are looking in the Central Valley of California. There are good neighborhoods, is typically a good job market, is strong demand due to the favorable climate and one can occasionally find some attractive deals due to the high number of foreclosures.
Now let's assume we can find a 1200 square foot home with three bedrooms and two bathrooms near schools and parks. Now let's assume that a cash buyer can buy the property for $150,000 and rent it out for $1100 per month. Is that a good deal? Most people can do simple back-of-the-envelope math and figure that $1100 x 12 months per year is $13,200 in gross annual rent. Then we subtract $2200 for property taxes and insurance. That leaves us with $11,000 per year, assuming we have no vacancies and no major repairs (generous assumptions). So if we pay $150,000 for the property, we expect to receive a 7.3% yield on our investment. Most people would say that is a reasonably good return and would not be swayed much by the ups and downs in housing prices because it is a "long-term investment."
For some reason that very simple logic is completely lost when it comes to stocks and bonds. We tell our family and friends to think about stocks and bonds in the same way they would think about real estate. Let's look to some parallel questions to see the similarities. Is it a good neighborhood? Is it a good industry? Is the tenant's income stable? Are the profits of the business stable? Does the tenant have too much debt? Does the business have too much debt? Can we trust the tenant to take care of the property? Can we trust management to take care of the company? What is the cap rate of the property? What is the free cash flow yield of the business? Are we getting a good return considering the risks involved? The last question applies to all investments.
Is a 7.3% cap rate a good return considering the time and effort required to be a landlord? Is it a good return considering the risk of vacancies, major repairs and the illiquidity of real estate? Is an equivalent cash flow yield a good return considering the risks of being a passive, minority owner of a publicly traded company? Is it a good return considering the sometimes violent price swings in the stock market?
We find great yields in bear markets, panics and crashes. And we are often unenthused or pessimistic about yields in bull markets. In other words, our outlook often runs contrary to popular sentiment. This is why we get puzzled looks from family and friends. The average person typically thinks only about recent price trends, completely ignoring underlying values or yields. Depending on how you look at things, a bull market or bear market can be the best of times, it can be the worst of times.
For more insight and investment research, visit us at IgnoreTheMarket.com.
