I just spoke with Tom Seto, Managing Director of Parametric Portfolio Advisors.  Parametric manages nearly $40B in client assets.  It focuses on buy-side asset management. The investment strategy is a statistical quant driven model that is essentially the polar opposite of fundamental analysis.  Its strategy is more along the lines of modern portfolio theory (MPT) in which it maximizes portfolio return and minimizes risk buy holding various assets chosen from its back tested quant models.

Parametric does not aim to beat the market, but to achieve client specific objectives such as lowering tax liability, variance, and volatility.  Parametric has a unique business model and has had spectacular growth in recent years.  When Tom joined Parametric they managed only $2B, which was a small in the investment world.  Today it manages $40B and assets under management (AUM) continue to grow.

Tom graduated from the University of Washington with a degree in electrical engineering.  After a career as an engineer he decided to change his career path and got his MBA from the University of Chicago.  After graduating he worked at Barclay’s Global Investment for seven years before it was bought out by the behemoth Blackrock. He was on senior leadership but decided to take an opportunity at Parametric which allowed him to go back to Seattle, a city where he always wanted to end up.

Efficient Market Hypothesis

Tom was groomed in the efficient market hypothesis, a dominant market ideology from Chicago.  For the most part, he agrees with the efficient market hypothesis and believes it’s extremely hard, if not impossible to beat the market consistently.  This suits Parametric’s business model well as its products seek to track specific market segments.

Capital Flow Trend

Interestingly, one of Parametric’s many successes is its Emerging Markets portfolio which has outperformed the market by 1% to 2% annually.  While this seems marginal, it is a tremendous feat when managing billions of dollars with low variance and volatility targets.  This performance is especially attractive to institutional money as clients with hundreds of millions of dollars are seeking beta (broad market exposure) and low risk as measured by variance.

Market Anomalies

Berkshire’s huge success has to do with not only good stock picking, but also favorable market conditions since 1965. Recall: A rising tide lifts all boats.  While Buffett had the advantage of roaring stock markets, he also achieved alpha by returning 20.2% annually compared 9.4% for the S&P 500.   So of course I had to ask Tom: “If markets are efficient, how do you explain Berkshire’s outstanding performance.”  Tom replied:

Imagine you have a thousand money managers with a thousand different strategies. By the law of distribution there has to be some that do exceptionally well and some that do exceptionally bad. It does not have to do with how “smart” the manager is, but it has more to do with the fact that he was lucky and perhaps incidentally chose a strategy that worked. For every 10 to 20 managers that do exceptionally well such as the SAC Capital and Bridgewater Associates, there are hundreds (if not thousands) of others that don’t.

So why try?

While I agree with the outcomes of the argument – some do exceptionally well, most don’t – I disagree with the reasoning.  Take basketball.  A small portion of basketball players make it to the NBA.  Many play basketball, but most are average.  Only the exceptional ones make it to pro basketball – say, one if thousands if not millions.  This distribution not only looks similar to the success in money management, but the reasons for the outcomes are similar as well.  Those who make it into the NBA possess exceptional skill and those who succeed in money management likewise possess exceptional skill.

That said, this is an ongoing debate about investments between academics and practitioners.  One camp believes its impossible to beat the market and thus no effort needs to be expended.  The other believes that they have the “secret sauce”.  As for the latter is concerned, they play a game where opponents think effort is inconsequential.

I haven’t posted in the last couple weeks as I’ve been meeting with different money managers in the Seattle area but I want to make sure I write about my 45 minute call with Gary Furukawa.

A brief background – Gary Furukawa is the co-founder of Freestone Capital Management an investment firm based in Seattle that has $2 billion assets under management (AUM).  Gary founded the firm in 1999 and ran the company as President and Chief Investment Officer until he relinquished (if I recall) the role in 2007.  Prior to Freestone he graduated as Magna Cum Laude from the University of Washington and worked at Solomon Smith Barney for 11 years where he managed $500 million in client assets.

Needless to say, he has a wealth of experience and knowledge.  The primary question I had for him was: What does it take to become successful in the investment industry.   Gary is a no bullshit guy and shoots you straight (something I appreciate and always try to improve).

He distilled it into two criteria:

1. Instinct
2. A nose for opportunity

Instinct – According to him, in the upper echelons of success in money management, either you got it or you don’t.  The “instinct” for investments can’t be taught.  All the schooling and training in the world can’t give you what it takes to be a truly exceptional money manager.

However, in my opinion this begs the question, “How did the instinct originate? Where did it come from?”  Blink: The Power of Thinking Without Thinking by Malcolm Gladwell discusses the art of thin slicing and essentially how instinct trumps the “rational” approach to making decisions.  Instinct is actually acquired – knowingly or unknowingly – by individuals that are experts in a field through time and experience.  For example, a particular tennis coach can call a fault with 95% accuracy when the ball is in the air before the server hits.  First, the ability seems bizarre to say the least.  But second, as bizarre and supernatural as it may seem, this skill was acquired through time.  Perhaps through 10,000+ hours of teaching tennis, and years and years of watching serves.

Personally, I believe instinct plays a huge role, but whether it can be acquired through time is subject to debate.

A nose for opportunity – I believe this follows closely to his first point about instinct.  The idea of buying a dollar bill for pennies appeals to people or it doesn’t.  Some people just “get it” while others are “ho hum”.  Certain individuals have the knack for spotting opportunities and acting on them.  It’s something hard – if not impossible – to teach an individual.

My follow on question for Gary was, “Well, where does the margin of safety and risk management come into play?” After all, the concept of margin of safety is an established tenet for value investors.  From Gary’s perspective, if you have the first two right (the instinct and nose for opportunity) risk management will follow.  At the outset this seems ludicrous especially if you consider the huge market for risk analysis, but then again, crowds don’t define right and wrong.  You’re either right because you’re right, or wrong because you’re wrong – not because people believe otherwise.

If you consider his statement in the context of buying undervalued assets his statement holds.  Good instincts and the ability to recognize opportunity tend to bring the attendant margin of safety.  A good deal should scream at you when you see it.  If you have to debate whether the $100 perfume bottle is a good deal, it’s probably not.

There you have it – the hallmarks of a great money manager according to Gary Furukawa.

Why does value matter?

When it comes to value investing determining value is 80% of the battle.  Knowing the value of a business requires (1) deep knowledge of the industry and (2) a framework to determine value. Just because you know Apple will sell more iPads this year than last is not enough to determine the value of the company which is heavily dependent on income.  While you might reasonably predict that revenues for Apple will increase, and growth will come from certain segments, it is much more difficult to predict what will happen to income.  Income depends on many factors.  How will their bargaining power with suppliers be affect profit? What will competitors do that may influence Apple’s competitive position for better or worse?  Will the company maintain pricing power with respect to inputs (costs)?  Will the company continue to innovate and forever stay ahead of the curve?

Valuing a business, therefore, requires a solid understanding of the company, industry, and factors that may affect it.  That is why it’s imperative to know your boundaries and limitations – and especially when you’re getting close to it.  Knowing what the general population knows isn’t enough.  You must dig deeper and hone your understanding of the business.

In Margin of Safety, Seth Klarman presents four methods for determining value, all of which have their advantages and disadvantages.  In some cases, using more than method might be the best solution.

1. Net Present Value (NPV)

This is probably the most widely used metric to determine value.  This is a concept that everyone in business school and the finance industry learns.  Adding up all the predicted cash flows and discounting back to today’s dollars using the appropriate discount rate - usually the prevailing market rate.  For example, to determine the value of the bond today, you would estimate all the future interest payments and the principal return when the note is due and apply the appropriate discount rate.  The number yielded will give you the net present value (or price) of the bond.

The same method can be applied to an enterprise.  If future cash flows can be precisely determined, NPV would be the best method of valuation.  While it makes sense in theory, in practice businesses never have earnings as consistent as that of a bond.  Nonetheless, for businesses with consistent earnings and which you believe will continue to maintain their earnings power you can assume the earnings will roughly be the same.  To protect against the unpredictability of the future such as earnings volatility, exogenous events, industry deterioration, you should build in a margin of safety to protect against this. No matter how good you are at analyzing a company you can never be precise about values nor predict the future.  The only guard you have against events out of your control is to require a margin of safety.  The more uncertainty you deem an investment, the larger the margin of safety you must require.

2. Liquidation value

Liquidation value is the rock-bottom value of a company.  Generally, companies in liquidation rarely obtain top dollar for their assets.  Rather, they tend to sell out at clearance prices to buyers that get a bargain.  For example, Circuit City liquidating 10,000 laptops in two days is going to receive much less than Best Buy would if Best Buy were selling the same 10,000 laptops during their regular course of business.  In addition to the extenuating circumstances of liquidation values, it does not take into account going concern value – i.e., value of the company if it were operating.

A quick hand method that can serve as a proxy for liquidation value is the net current asset value.  This takes the company’s current assets (assets turned into cash in less than a year) such as accounts receivable, inventory, marketable securities and nets current liabilities (monies due in less than a year) such as accounts payable and short term notes.

Another more conservative method is the net net current asset value.   This approach takes current assets and deducts all liabilities both current and long term.  This will yield a bare minimum value of the business since the long term assets such as property, plant, and equipment are not taken into consideration.  Generally, if you can purchase a company for less than the net net current asset value you will receive a good margin of safety.

3. Private party transactions

This method values a business based on what a private party would be willing to pay for the whole company.  For example, Company X makes IT components and current earns $50,000 per year.  The market is very optimistic about its prospects and is generally willing to pay a premium in the stock market for this property at forty times earnings.  This will give Company X a market cap of $2,000,000.

Now, would a private party be willing to pay as lofty a price as general market?  Generally the idea is, no.  People purchasing whole business tend to be more realistic than those who purchase pieces of paper (stock certificates) on the internet.

Clearly, there are flaws in this method.  Private parties have and do overpay for business which is why this is a metric that should be used in conjunction with other methods.  

In any event, this serves as another method to measure value.

4. Stock market value

Probably one of the least reliable methods subject to supply and demand in the market.  General price movements in the market are usually caused by investor sentiment as opposed to the fundamentals of the business.

However, when valuing some assets such as closed-end mutual funds or trust companies that have assets consisting almost completely of marketable securities, the stock market valuation is likely the best and only method of valuation.

There you have it.  Four methods to valuation that Seth Klarman and many other value investors use to buy or sell securities.  While, descriptions for the methods above are not meant to make you an “analyst”, it gives you an idea of what value investors are looking for.

I just met with Bill Borland who is currently a pastor of New Community Church who was recently Managing Director of  Russell Investments.  His background is quite impressive and was even mentored by the CEO of Russell.  He suggested I read The Common Denominator of Success by Albert Gray.

I don’t know much about Gray, aside from what I’ve just read from the article above.  However, it is clear that Gray has caught on to the key determining factor of success and has distilled it into one sentence:

“The common denominator of success – the secret of success of every man who has ever been successful – lies in the fact that he formed the habit of doing things that failures don’t like to do.”

The foregoing sentence in one stroke has captured so much.  Think about all the things worth having in life.  Regardless of whether it is wealth, health, spiritual, social, or physical goals, the line of demarcation for those who achieve their goals and don’t is the ability to form a habit out of things others don’t like to do.

This hits home to me, the blogger.  For those who blog, every blog is a test of stamina and fortitude. My forte is not writing, although I love communication, but even if you are a writer I figure the hardest part of that is writing (i.e., overcoming writers bloc, etc.).  In many cases people fail to achieve their goals because they never stick with it in the tough times to see their vision through.

Take it from a Pastor

This whole thing came to mind when Bill brought up the challenge of delivering a message on Sunday.  For him, meditating and writing the message is not the hardest part, but rehearsing it is.  He believes it easiest for pastors to be remiss when it comes to practicing the message.

As a result, he usually rehearses the message straight through at least six times and doubles up on the beginning and ending.  So a minimum of twelve times for the opening and the closing which he deems the most important part of the message.  Additionally, special attention is paid to the closing where the delivery needs to come from the heart to drive the point home.

He’s only been a pastor for a relatively short period of time (a few years or so), but he’s forming a habit out of things preachers don’t like to do (I’m sure the list goes on).  I trust his messages will do what it was intended to do and the carefully prepared and rehearsed messages will have a strong impact on its listeners and change some lives along the way.

What it Means for the Investors

Every investment requires diligence and homework.  The starting point for securities is reading the annual report and studying financials.  If you’ve ever read an annual report they tend to be 100 to 300 pages long and can put you to sleep.  But if you want to be a serious investor there is no shortcut.  While I couldn’t find exactly where I read it in a great book on financials by L.J. Rittenhouse, something like 70% of stock buyers don’t read the annual shareholders’ letter and 90% don’t read annual reports.

These are the starting points of stock investing yet the vast majority of people cannot even claim to do this.  The reason is twofold: either they are too busy to do this or they have delegated this to someone else (more on this in later posts).

Reading private placements, operating agreements, deeds of trust is part and parcel to invest in bonds, but many investors and money managers just rely on rating agencies’ seal of approval as their due diligence.  And we all know where that has lead us since 2007.

To call yourself an investor you must put in the hard work.  You have to study the industry and have a deep understanding of the business.  Not surprisingly, some have made it a business to love doing the analysis that others hate and that’s exactly why they succeed at it.

What this Means for the Initiated

You need to form good habits, but not just any habits.  In particular, focus on habits that tend to be most rewarding which are habits that other people don’t like.  For example, if you like basketball, you’ll like to be on the court.  Great, most players do.  However, do you like basketball when it comes to drills and conditioning?  Many will say that’s not the part they look forward to most.  But here is where you can really standout and make a difference.

Gray said, “Men form habits, and habits form futures.”  What habits do you have and where where are they leading you?

I recently read a book called Margin of Safety by Seth Klarman.  It was referred to me by a director of Blackrock when we met at Blackrock Alternative Advisors’ (BAA) downtown offices in Seattle.  Prior to meeting with Jeff I had never heard of Seth Klarman.  Not surprisingly, it is one of the suggesting readings at Columbia’s Value Investing course.

For the record, when I looked at this book on Amazon a few weeks ago it was selling for $1500!  It has since dropped to $500 for those of you who wish to buy it.

I finished the book while in New York and really enjoyed it.  The book is broken down into three parts:

I. Where Most Investors Stumble
II. A Value-Investment Philosophy
II The Value-Investment Process

In many ways, the book is akin to The Intelligent Investor and uses many of Ben Graham’s principals such as “Mr. Market” and the margin of safety.  Like many successful investors, Seth Klarman is clearly part of the Graham and Dodd circle.

In the ensuing posts, I will write about nuggets of value I got from the book.

Performance Derby

Klarman writes extensively about the “performance derby”, essentially, the goal of mutual funds and institutional investors focusing on relative performance instead of absolute performance.  Whenever you hear how an investment class or fund is performing relative to the S&P 500, that’s an example of relative performance.  It’s how an investment compares to the broader market.

Benchmarking is common practice and is frequent used as a yardstick for quick comparisons.  However, it is not without its drawbacks.  Investment managers that try to beat the market quarterly or annually are short term focused.  Of course they want to beat the market, but more importantly, they don’t want to under perform the market.  After all, to stand out of the pack and under perform the market in just one year is a terrible thing – even if their average return is higher than that over the market for 10 years.

With this short term performance derby orientation, investment managers are likely to sell investments that are in fact good buys and buy stocks that are performing well and in favor to not miss the ride.

This provides value investors with great opportunity to buy undervalued stocks at even a cheaper basis.  This is exactly why you have the excesses on the sell and buy side.

How to Define Risk

Many finance professors and investment professionals define risk as volatility. Volatility (also known as “beta” at universities) is the tendency for the stock to fluctuate more or less in relation to the market. The more a stock fluctuates in relation to the market, the higher risk and vice versa.

Klarman in very simple terms defines risk by two components:

1. The probability of loss
2. The potential amount of loss

It’s amazing how sometimes you can over complicate the simplest things in life (and investments).  Essentially, when thinking about risk you can reduce it to those two components.  Of course this assumes that you don’t have unique liquidity needs.

To all my readers, I sincerely apologize for not keeping up with my blog. It’s been nearly seven months since I’ve blogged. Much of it was motivated by financial and time constraints: blogs usually don’t pay the mortgage and there are only 24 hours in a day.

So, I’m going to make a commitment and try to blog a couple times per week. Since it’s been a while, after receiving my first update you can unsubscribe if you wish – there will be no hard feelings. These updates will keep coming so if you wish to jump ship, do it now.

For writers, this goes without saying, but writing really does take a lot from you. You must plan for it, you must do it, and you must deal with the consequences of it – through feedback that is good or bad.

My goal for resurrecting this blog is twofold:

1. To organize my thoughts on investments and flesh out investment topics and ideas more formally.
2. To hopefully educate and add value to those interested in the topic of investing, personal development, and personal finance. However, I think for at least the near term, it will be “investment” heavy.

I’ve recently come back from my visit to Columbia University and purchased nearly all the books they had on Value Investing. For those of you who don’t already know, Benjamin Graham, widely known as the Father of Security Analysis graduated from Columbia and subsequently taught classes on Security Analysis there. Graham also later came to be known as Warren Buffett’s mentor.

In the ensuing months I will start writing about my readings and interviews, if any, from knowledgeable professionals in the industry. This Friday, I am tentatively scheduled for a call with Joshua Siegal, adjunct professor of Columbia University, who is the co-founder and Managing Principal of StoneCastle Partners which manages more than $2.6 B in assets predominately concentrated in the financial sector.  I’ve asked his permission to post our call on the blog and I’m waiting to hear back.

It is no surprise that the number one reason for divorce is money.  Furthermore, it is no surprise your placement in society’s totem pole is dictated by how much you make than any other factor – education, popularity, faith, morals, or good looks (sorry to spoil your day).  A stroll through today’s news will show that “newsworthy” people incidentally make a lot of money or they’re worth a lot of money. And if you’re not worth big bucks, knowing someone with money is just as good, think HBO’s Entourage. If you haven’t watched the show, it’s a series about Vincent Chase (starring Adrian Grenier) who hits it big in the movie industry and takes his entourage along for the ride.

Wealth and Worth

The media, your family, church and corporate culture all reaffirm the belief that wealth and worth are the same.  According to society you are better by having material possessions.  This explains why people are so consumed by Forbes “richest billionaires”; get rich quick schemes; climbing up the corporate ladder; the new or second home; and the expensive-unreliable European car.  People have 70 hour work weeks and sacrifice personal and family time to “get ahead”.

Tip #1: You can’t feel financially free if you continue to consume as society tells you to.

Relative Wealth Matters More than Absolute Wealth

Having money and possessions alone won’t do it either.  You have to have more money than your friends.  An article from Medical News Today shows a study conducted by Pennsylvania State University that concludes “relative income” has a stronger impact on personal happiness than “absolute income”.   People are generally not happy about driving a new Honda Accord (ahem, proud owner), but they are happy that they are driving an Accord while their peers drive the 1980s beater with a busted muffler.  This is known as I’m-richer-than-you syndrome.

Tip #2: You won’t feel financial freedom if your happiness is contingent on having more than your peers.  There is always bigger and better.

Start Feeling Financially Free

“Feeling” financially free is evidently linked closely to happiness.  The interesting thing is, it has more to do with your mentality and state of mind than it has to do with the size of your pocketbook.  It’s sad to see that so much happiness depends on hoarding and the diminution of your peers – but that is reality, to an extent.  These unbecoming tendencies are just like nasty habits.  But like most habits, they can be broken.

Some practical ways you can break your habit:

1. Admit. You can’t break a habit unless you admit you have one.
2. Autosuggestion. Pro athletes and leaders use this technique to achieve great results.  A simple process like speaking to yourself has tremendous effectiveness.
3. Accountability.  Confess to people you trust and have them keep you accountable.
4. Replace the bad with the good. When breaking a habit inactivity can aid remission.  Start replacing unproductive thoughts with productive thoughts.  Focus on congratulating the successes of other people (be genuine of course) rather than your lack of success. Enjoy your own lawn instead of checking to see if your neighborhood’s grass is greener.
5. Reward yourself. As you make progress, reward yourself for little victories. 
6. Forgive yourself. If you stumble – which always happens as you’re breaking a habit – forgive yourself.  Don’t get hung up.  Admit it and move on. 
7. Visualize. Another powerful tool athletes and great leaders use.  Visualize yourself without the habit and how much your life will be better for it. 

Acknowledging wealth is not worth and not comparing yourself to others is not enough.  “Feeling” financially free is not just a state of mind or worse yet, denial.  Ignoring your bills won’t make them disappear.  Nor is flippantly hitting the “kill” switch – bankruptcy.  The first step to feeling financially free is crafting reality to match sentiment. Start stopping the bleed by lowering expenses.

Consider expenses you don’t need…and cut them out.  Some examples:

• Eating out – Not Eating Out in New York has great tips on this
• Movie dates that cost $35 after tickets, popcorn and parking
• Tivo or other digital recorders
• Satellite radio
• ATM fees
• Golf and it’s expensive peripherals
• Latest iPhone, iPod, or anything that iJobs hawks at you
• Multiple digital cameras and video recorders
• Woot! (I had to throw this one in there for my buddy who’s a Woot! junkie.)
• Video game consoles and their $45 games, $60 games (my friend Nate, way more a gamer than I just messaged me to correct)
• ….

You get the point.  Obviously, these are just a few items you can live without.  If you’re honest with yourself and sit down you will find many things you can part with.  So, part with them!

Being overwhelmed with bills and expenses can prevent you from your road to financial freedom.  As you start to cut back and make progress, you stop living paycheck to paycheck and have flat screen TV bills looming over your head.

Last note, this article is not just for the lower and middle-income earners.  Even if you make $250,000 per year you can just as easily get caught in consumption or comparison mania.  The more you make, the deeper you dig.

Change your mentality, cut back and start feeling financially free today.

You’ve all heard of the phrase, “Let your money work for you.” If you’ve saved up enough money and amassed sizable savings, you might be thinking: Where should I invest my money?  While you can invest in stocks or bonds, another alternative is investing in funds.  Funds are typically run by money managers and can be public or private.  Different funds have different risk/return proportions and lockup periods where the fund requires you to invest for a minimum amount of time (months or years).

In the laissez-faire world of investments, money goes to its highest bidder – or place with the highest returns.  With so many funds projecting 8% to 25% returns, how do you determine which fund to invest in?  Technically, there are many criteria you can look at such as track record, risk adjusted returns, upside potential, and collateral.  However, the most important principal to finding the right manager is stated eloquently in the Gospel by Matthew:

“For where your treasure is, there your heart will be also.”

The first question you should always ask a money manager: Where do you place your eggs?  This will screen out 80% of crap investments in your “world of opportunities”.  When money managers hawk their financial wares and ask for your capital, judge them by the placement of their own.  Shakespeare had it right when he wrote, “To thine own self be true.”  If a manager had ten different funds (or opportunities), you can be sure the he will invest his money in the funds he deems most profitable and secure.

However, having a vested interest in the fund alone is not enough.  There are qualifications:

1. Do they have a meaningful amount in the fund?
2. If so, is it a good percentage of their net worth?

To no surprise, these are qualifications that Warren passes with flying colors.  He has more than 99% of his net worth in Berkshire Hathaway, and additionally, many of his family and friends have a significant amount of their net worth in Berkshire.  As I’m sure Warren would agree, there is absolutely no reason why – the prospect of doubling his money, getting 40% returns, hubris, or prestige – he would ever be tempted to jeopardize the money that is so important to those he cares most.

This shows why Warren builds a fortress balance sheet that can weather recessions worse than that experienced in 2007-2010.  As an insurance company, only Berkshire can insure large policies that no other insurance company in the world can underwrite.  When hurricane Katrina, Rita and Wilma struck the Gulf coast they paid out $3.4 billion in losses.  While this wasn’t a happy loss (no loss ever is), it wasn’t much of a hiccup for the company.

Now, some of you may not find it in you to ask about other people’s money.  Asking about where the money manager invests his funds might make you feel impolite – or even rude.  However, if someone is going to manage your money, you have a right to know about “their” affairs – at least to the extent it helps you to make a decision.  Part of a good investment relationship is being forthright on both sides of the coin.  You can be sure when the money manager qualifies you as an investor, he will ask about your affairs.

How to Buy a Short Sale – or a Foreclosure in King County

It’s been a while since I’ve blogged and I apologize for that.  My recent preoccupation with an investment property is to blame.  I’ve been in contract to purchase a short sale in Madison Valley and the negotiators are working with the bank to get final approval before the property goes to auction this Friday.  Meanwhile, I thought it’d be nice to share the process as it’s fresh in my mind, and perhaps you will glean something from it for your next real estate investment project.

My Target Neighborhood

I’ve been targeting a few neighborhoods that I think will yield the best opportunities.  One of them is Madison Valley in Seattle, WA.  In general, if you want to find a “deal”, focus on neighborhoods where there is likely to be mispricing. This is a fundamental principal that all great investors exploit like Warren Buffett, George Soros, Peter Lynch and Julian Robertson.

New neighborhoods or cookie cutter neighborhoods usually present the least opportunities for the real estate investor.  The reason is simple.  If the neighborhood is new, the homogenous homes make it easy to price.  The seller and the listing agent are less likely to misprice so that the property sells at deep discount.  Additionally, newer neighborhoods typically don’t allow you the ability to rehab (hence, newer) and add significant value through fixing up the property.

If you live in a neighborhood and all the homes were built by the same builder in 2004, why sell your home for $200k when the guy across the street with the exact home just sold for $300k?  However, if you live in a neighborhood where most homes were built in 1920 it’s a different story.  Some homes likely have remodels, so don’t.  In some cases brand new homes have been built on old sites.  These types of scenarios allow the intelligent investor to exploit.

Furthermore, in the bank’s approval process, they request Broker Price Opinions (BPOs known as bank valuations) which are frequently subject to flaws when neighborhoods are heterogeneous and not as easy to value.

Seattle is a developed city with a wide range of neighborhoods with many homes built from the early 1900s and on.  It represents an eclectic mix from early 20^th century styles to post-war styles.  Neighborhoods such as Leschi, Madrona, Columbia City, Wallingford, and pockets in West Seattle present great opportunities because range of homes can range widely.  Gentrifying and transitional neighborhoods also create opportunity as well as it requires specific knowledge to accurately value you the property.

Valuation

When investing in real estate, seventy percent of the battle lies in buying at the right price.  The remaining thirty percent comprises fixup, financing, maintenance, permits, etc.  The good thing about determining price is that you don’t have to be exact, but you have to be roughly right.  In fact, it’s almost impossible for two different people to arrive at exactly the same valuation.

When valuing properties in Madison Valley, I looked at three groups of homes: homes sold within the last year with a heavier weight for homes within the last six; pendings sales with a heavier weight on non-short sale homes; and active comparable listings noting days on market.  If possible, I try to think of the distance in terms of “blocks” as opposed to quarter-mile or half-mile radiuses (commonly used by realtors).  This allows more precision and puts you in the shoes of the buyer where a quarter mile makes all the difference.  During preliminary analysis, I pull up Google Street View and “walk” through the neighborhood and make mental notes of changes such as lot size, curb appeal, traffic, and blocks with curbs and blocks without.

When I determine price, I price the property where I think it would be a good deal on the market.  As in, if anyone were planning on buying a home in Madison Valley – in my price range, of course – would definitely buy my property.  After I determine that price, which is already conservative since they’re getting a deal, I build in a margin of safety where I can easily discount 5% and still make money. Keep in mind 5% is a ton when net margin for nationwide homebuilders is about 5%.

Fixup

This project is a large project that will require more money than usual to fixup.  The property is essentially a shell and just has a roof, outside walls, and some interior framing.  The property needs plumbing, electrical, framing in the lower areas, windows, sheetrock, roofing, a new driveway, siding, flooring, kitchen, bathroom, and landscaping.  In addition to budgeting for known items and issues, I built in a buffer for cost overruns.  In this case, $30k.

Putting in the Offer

This step requires lots of persistence and patience from the buyer’s agent.  Many buyers’ agents wince when it comes to working with an investor.  Some agents have investors but effectively fire their clients through lack of service.  Finding investment properties requires much time and commitment on the agent’s end.  The agent needs to screen, drive, analyze and value a ton of properties and neighborhoods.  Finding deals requires casting a large net which in turn burns the agent’s time, their most valuable commodity.

As an investor/agent, I obviously don’t mind spending time looking for deals for myself as success pays off tremendously.  When it comes to investors, I actually prefer working for them because they have a high sense of loyalty to me and my services.  The truth is, investors are likely intelligent enough to do what I do, but don’t have the time nor the desire.  As long as I’m helping my clients make money, this puts me in a good position because I get paid to acquire the property (as the buyer’s agent) and to dispose of it (as the listing agent).

It’s not uncommon to put in seven or eight offers until you get one acceptance. Even then with the acceptance from the seller, if you’re purchasing a short sale, you still need to wait for bank approval.  I put in multiple offers on different properties in Madison Valley before one finally got mutual acceptance.  Since it’s a short sale, the offer is contingent on bank approval.

To my dismay, Bank of America rejected my offer last week and responded with the following:

This short sale was submitted to your [note holder] for approval and was denied due to (insufficient offer, not willing to sign a deficiency agreement, or contributing to the loss). However, if the seller is willing to sign the deficiency agreement or contribute to the loss or have the buyer increase their offer; we may be able to reconsider the short sale. Please send us any updated documents for the short sale to be reconsidered.

This was an automated response sent by the bank which did not take into account, what I believe, as the bigger picture.  The bank will likely get less since buyers have less information at the auction and tend to bid less to compensate for unknown risks.  At this point it looks like the bank will not approve the offer and I will just make my trip to the auction to bid for the property.

The Right Partners

I find myself extremely blessed to have partners that I like and trust. While they say you never know what you’re made of until times are tough, I believe that we will persevere as a partnership.  Why didn’t do this deal myself?  Because this deal requires more than $200k in equity, and the partners bring other value to the table besides cash.  While I could’ve done the project with less money, the equity cushion provides a buffer to absorb losses and decreases the private loan needed – more on that below.

Private Financing

In this market, financing presents the biggest hurdle.  In many cases you can get funds through private loans or hard money loans.  The key, however, is to get the loan and not lose your shirt in the process.  Lenders typically charge you points and interest.   In King County, the fees typically range from 3% to 5% for points and 10% to 12% interest.  Loan terms are usually 6 to 9 months which means cost of funds are about a 20%. While this seems high, investors pay these fees because they lack alternatives.

While I know multiple sources for private lending, I also know some dentists who have money sitting in the bank earning little or no interest.  Why pay high fees when you don’t have to?  I put together a couple buddies that are dentists and told them I’d give them 10% interest instead of the measly 1-2% they would otherwise earn on their CDs.  I drove them by the property so they could see their collateral and see what they would be loaning money on.

While, these individual lenders are my friends, business is business.  This loan will be treated just as if I were getting the loan from BofA or Chase Bank.  We will formalize the loan through three key documents: 1) Loan Agreement, 2) Promissory Note, and 3) Deed of Trust. The loan agreement basically states the terms of the loan, what the interest rate is, late fees, default rate (if any) and when the note is due.  The promissory note is essentially the promise to pay the loan.  The deed of trust is the security instrument that gives the lender their interest in the property and the right to foreclose if the borrower defaults.   

Bidding at the Auction

Last week I went to the auction at 10am in Bellevue familiarize myself.  I’ve been to numerous auctions in Seattle, but none in Bellevue up to that point.  In King County, there are two locations you can purchase foreclosures 500 4^th Ave (Seattle) and 3535 Factoria Blvd SE (Bellevue).  The property is slated to auction this coming Friday at 10am.

Honestly, getting this one deal started has definitely taken more work than I expected.  Every step of the process has been so rewarding, from scrubbing deals to getting into contract; from putting together the operating and subscription agreements for partners to drawing up loan documents for lenders.  This serves as a great learning process, not to mention it pays the bills (hopefully).

Book Review: The Little Book that Beats the Market

What if you heard there was a “Magic Formula” that said you can beat the market.  You were told that the little guy has a chance to outperform stock market analyst and portfolio managers?  No need to just invest in index funds and wait mindlessly while your investment grows (or diminishes).

In his latest piece, The Little Book that Beats the Market author Joel Greenblatt goes through a simple strategy and explains in plain English how to achieve higher returns than average by just running through a formula and adjusting your positions quarterly.   He calls this the “Magic Formula” that would’ve gotten you 30% annual returns from 1988 – 2004.

Before you write-off the “Magic Formula”, let me inform you the person that devised the strategy is the author of You Can Be a Stock Market Genius, a popular and well known investment book.  And even more impressive, he was founder of Gotham Capital that had an annual return of 50 percent from 1985 to 1995.  That’s right, 50 percent.

As a follower of Warren Buffett, I must admit I was skeptical of Greenblatt just from merely the titles of his books, but after reading both I really enjoyed what he had to say.

High Return on Capital

First step: Buy a good business.  A good business has high returns on capital (capital is what you invest, return is what you get).  For example, Business A requires $100,000 of investment capital and makes $50,000 in profits per year.  That’s a 50% return on capital.  Investment B requires the same amount of $100,000, but only makes $2500 per year – a 2.5% return on capital.  While this is a simple metric it quickly helps you determine which businesses are good and which are bad.  It helps show if the business can command higher prices for their products and whether they have a brand they can leverage to create more profits.  Companies in low margin businesses with no brand or competitive moat tend to get riddled with flagging businesses.

Additionally, businesses with high returns on capital tend to mean that management is in the right business and is likely managing the business well.  This “excess” return on capital for good businesses compared to alternative businesses allows flexibility for management to whether storms and return capital to shareholders in the form of stock buybacks and dividends (both highly valuable).

High Earnings Yield

Second step: Buy cheap.  As we saw in Jimmy’s Gumballs example, buying 50% of the company for $3,000 in order to receive $618 in earnings is a worthwhile investment (21% annual return).  However, if Jimmy wanted to sell half of the company for $20,000 what was a great investment now amounts to a measly 3% annual return.

Probably the most widely used shorthand for determining whether a stock is overvalued or undervalued is the P/E ratio – price to earnings ratio.  The lower the P/E, the lower you’re paying for the business and vice versa.

There are many great companies in the world of stocks, but the challenge is finding then at a good price.  One of the biggest mistakes people make when buying a great company is paying a dear price. A great company does not make it a great investment. The quality of the company must correlate with the price you pay.

Magic Formula

The last step: Combine Step 1 (buy a good business) and Step 2 (buy cheap). There are currently 7,000-8,000 publicly traded on the exchanges.  Let’s say you limit yourself to only the 3,500 largest companies in terms of market cap.  Next, rank the 3,500 issues in your “stock universe” from 1 to 3,500 based on return on capital (#1 being the best).  Now do the same for earnings yield.  Finally, add the two numbers and you end up with ranking of the best companies that have high return on capital as well as earnings yield.

A company that’s cheap (high earnings yield), but really low return on capital gets weeded out.  And a company with great returns on capital, but already has the market’s attention and trading for astronomical prices get weeded out.  The formula leaves you with good and cheap companies.

Below is an excerpt from The Little Book that Beats the Market that compares the Magic Formula results to the general market and S&P500:

Click for larger view (image minimized to reduce load time)

According to Greenblatt’s table, if you would have applied The Magic Formula principal from 1988 – 2004, you have returned 30.8% during that time period while market returned 12%. Honestly, it does sound too good to be true, but at the same time the system – while stupidly simple – makes a lot of sense.

A Few Downsides

1. While I trust his stats, I haven’t looked into it and cannot verify the results.
2. Historic returns, while indicative are not conclusive of future returns.  I feel more comfortable buying a stock that I know – see, touch, and feel – like Coke or P&G.  The strict formulaic approach buying whatever the “system” tells me to still does not sit well with me.
3. This requires you to monitor your positions and make quarterly adjustments or “re-balancing”.  Greenblatt rightly suggests you can mitigate taxes by waiting to sell your wins for a year to get long-term capital gains.  And if losses, selling them before the one year mark to get short-term capital losses and current year deductions.  While this mitigates your tax obligation, it doesn’t compare to the tax advantages buying and holding a stock indefinitely.  Even if you pay 15% long-term capital gains (more favorable than short-term capital gains rates typically taxed at ordinary income rates), you’re still remitting 15% back to the government annually.  Alternatively, if you can hold a stock for 30 years and ride the wave (hopefully upward), instead of remitting 15% of your gains annually, you can let that “taxable amount” compound (since you don’t pay the government until you sell, although Obama might change this).  Essentially, you get to invest borrowed money from the government interest free.
4. If this did work and everyone started following it, it would be self-defeating.

In conclusion, I like the simplicity of buying good businesses on the cheap.  You can’t go wrong with that.  However, as an active investor, this should be a starting point not the ending point.  Over time if you wish to beat the market you need to understand what the company does before investing in it; understand the industry; read the financials; and believe the company has a durable competitive advantage.