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| Jim Spence |
Many times over our twenty-seven years in the investment business we have published written newsletters that reference a generalized overview of our approach to investments. The concept begins with the premise that essentially there are basically three general areas of investments (business, income producing real estate, and interest bearing instruments) and these three areas are constantly competing for the flows of investment capital in free markets. While some might argue that rare art, commodities, and raw land are also “investments” we would argue that funds committed to these areas are better defined as “speculations.”
We readily concede that a formidable case can be made that everything about human existence is “speculation.” However, if you do accept the basic premise that an investor must decide if he or she should place his or her long term purchasing power in interest bearing instruments, income producing real estate, or a business enterprise, then there is plenty of room for discussion. We proceed.
Cycles: We think it is helpful to contemplate the condition of the markets for interest bearing instruments, shares of business enterprises, and income producing real estate within a historical context. Let us begin by considering the fact that there have been a number of “cycles” for real estate, common stocks (shares of business), and bonds in modern history. Each of these asset classes has enjoyed marvelous and often quite extended periods of popularity and great relative performance. Each has also experienced excruciating periods of decline or tedious and protracted periods of stagnation.
Predicting when one particular asset class is going to become popular or unpopular is tricky. However, it can be extremely useful to at least remind ourselves of what has been going on in the most broad and generalized terms in each class.
Bonds: Bonds (U.S. government bonds) have had two remarkably great periods of relative risk-adjusted performance in modern history. The first occurred with the onset of Great Depression when interest rates plunged and then remained very low for an extended period of time. Investors who owned long term government bonds in 1928-29 and held them for many years found that they were exceedingly popular investments until the 1950’s. Purchasers of long and intermediate term bonds saw those holdings begin a long and difficult period of decline during the 1950’s. Government bonds began another phenomenal risk-adjusted performance period when interest rates hit an amazing secular peak roughly thirty years ago. Investors who purchased long term government bonds in the early 1980’s took positions in instruments that would become amazingly popular investments for three decades. And accordingly they delivered wonderful risk adjusted returns. Intermediate and long term bond prices are still near all time record high values and correspondingly LOW current yields.
Real Estate: In commenting on income producing real estate, we must begin by saying that it is most certainly more difficult to generalize about real estate than it is to do so with long term government bonds. Most surely the onset of the Great Depression was an absolutely horrible environment for most real estate values. And during most cycles the performance of income producing real estate properties have been “location” dependent. During a handful of cycles since the Great Depression nearly all income producing real estate has appreciated spectacularly. Until the real estate bubble popped three years ago in most areas of the country income-producing real estate had been the “darling” of the investment world. At cocktail parties during the first seven years of the decade investment discussions were dominated by talk of the marvelous increase in property values. It had been hard to go wrong with commercial and residential property in the vast majority of locations from 2001 to 2007.
Businesses: Investments in businesses (shares of common stock) behave more like real estate than they do like government bonds. We say this because like real estate, business investments rely on many economic factors for success or failure, whereas the interest rate level is the overwhelming key factor for government bond values. A great bull market for the share prices of most common stocks began in the early 1920’s and ended in October of 1929. Shortly after World War II another bull market for common stocks began and it lasted nearly twenty years. Yet another great bull market for stocks began in 1982 and this one also lasted eighteen years. Since the 21st century began, common stock averages have been terribly stagnant. They have hardly been the “darlings” of the investment world. However, like well located real estate, the share prices of truly well-positioned businesses have continued to prosper and reward investors through this most recent period of relative market average stagnation. Diversification and trends: What does all of this mean? First, we think this means the intelligent investor should hold investments in all three areas (real estate, common stocks, and interest bearing instruments). Second, we think the current GENERAL trends for values (which are subject to change without notice) are as follows: Income Producing Real Estate = Declining for several years now, Common Stocks = Rising since March of 2009, Intermediate and Long Term Bonds = Values have been rising (yields falling) for thirty years. A few final thoughts: Owning a home and or commercial property in the best possible location is usually a good idea though it is possible when a bubble forms to grossly overpay even for a “great location.” Still, year in and year out superior decisions on “construction quality” and “location” will usually lead to better investment results on real property.
Good decision-making on common stocks can be rewarding. However, overpaying for well-positioned businesses is also very common, particularly at the end of bull markets. Still, year in and year out keeping a professional eye and ear open when deciding which businesses possess superior financial characteristics and durable competitive advantages will lead to better investment results. As time marches on the age old questions will continue. What will interest rates do in the near future? When will the drop in interest rates end? Is the stock market finally out of the doldrums? Have property values bottomed and if so where are the best locations? We don’t know who knows the answers to these questions but we do know that knowing the precise answers is not required for long term success. We think intermediate and long term bonds without interest rate step provisions will produce subpar returns. We think the time it will take for the next boom in real estate is far off in the future. If you are going to invest in common stocks your success will depend on proper understanding the dynamics of three things, the underlying business, underlying business, and underlying business.
Real Estate, Interest Bearing Instruments, & Businesses
From the Daily Caller - by Robert Goldberg - Nearly a billion people watched as the 33 Chilean miners were rescued from their accidental prison below the earth. And millions more made their safe escape possible through innovations in medicine, telecommunications and engineering. Writing in the Wall Street Journal, Daniel Henninger observed, “If those miners had been trapped a half-mile down like this 25 years ago anywhere on earth, they would be dead. What happened over the past 25 years that meant the difference between life and death for those men?” His answer: market-driven innovation. Henninger continued: “The Center Rock drill, heretofore not featured on websites like Engadget or Gizmodo, is in fact a piece of tough technology developed by a small company in it for the money, for profit. That’s why they innovated down-the-hole hammer drilling. If they make money, they can do more innovation. “ Read more
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