I came across this rather interesting YouTube video by a fellow Singaporean. In this video, he audaciously proclaimed that value investing is dead. Quite a bit of a shocker, isn’t it? I mean, one of the greatest investors in the world are value investors. People like Warren Buffett, Charlie Munger and even “The Big Short” Michael Burry are value investors. However, the fascinating thing is that although these investors have made significant profits in the past, their performance in the last ten years is lacklustre. Most value investors have failed to outperform the market in recent times. Why is this so, and what has this got to do with real estate?
The very first article I wrote on this blog was on the profitability of the J Gateway condo. Those who approach J Gateway from a value investor’s perspective would never think that this project can make any money. The main reason has got to do with how value investors think. Value investors do this by first calculating the intrinsic value of the asset. Then, they compare this value to the current asset selling prices. If this difference is significant enough, they will purchase the asset. Once the asset prices meet or exceed their intrinsic value over time, these value investors dispose of it and collect their profits. Sounds simple right? However, this logic has severe flaws, and I will highlight and expand on these points given by the Chicken man himself.
Assumption of a Business Life Cycle
Value investors find the intrinsic value of a stock is by doing a simple exercise. First, you break down the entire company into numbers. Cash flow, P/E ratios, EBITA, DCF, are just some of the financial data these value investors use. After applying these statistics to a formula, you would arrive at an intrinsic value of a company. The fundamental flaw with this calculation method is the assumption that things will remain constant.
However, we all know that the business landscape is never constant. A company is no different from a living organism and follow a life cycle. Hence, depending on which stage you calculate this value, the same numbers can interpret very differently. For example, if you calculate the intrinsic value where the company is at maturity, everything might look excellent. But what happens next might be the tail end of the company cycle, where profit and sales steadily decline year after year.
On the other hand, intrinsic values will look particularly overvalued at the early stages of the company. But once the exponential growth factor kicks in, intrinsic values will jump significantly. By the time the value investor works out their calculation, they would already have missed the boat on the most significant capital appreciation of the company.
Economic Moats Are Just an Illusion
In addition to purchasing stocks at undervalued prices, Warren Buffet also mentions acquiring companies with significant economic moats. Economic moats are barriers to entry, making it difficult for competitors to enter and capture market share. If you were to draw a line, there is essentially a spectrum where businesses can fall in. Either they can be a perfect monopoly or a perfect competition. Airline companies are your classic example of companies with a perfect competition where they only earn $17.75 per ticket. And this was back in 2018, before the pandemic days.
On the other hand, you have companies like Google who almost have a perfect monopoly of the search market with a market cap of $2 trillion. You can essentially add up all the airline companies globally, and they will still be far less valuable than this single search engine giant.
The main flaw with purchasing companies with solid economic moats is the assumption that these moats will exist for the years to come. In the past, moats used to last and hold their own against invading armies. But in today’s growth and speed of innovation, some moats become irrelevant as new technologies become available. You don’t need to look far at what happened with the Sony Walkman, Nokia phones, books stores and VHS tapes.
Innovating Constantly Is the Only Way to Create a Permanent Economic Moat
The only way to keep your competitive advantage in today’s climate is to innovate constantly. This means that you will need to set aside significant funding from time to time for this purpose. However, doing this will hurt the short-term intrinsic value of the stock. In a way, this is kind of ironic. From a valuation perspective, you might think that picking up undervalued stocks of company A might be a terrific deal. But what you might not discover is that the entire company might be irrelevant in the next few years.
A classic example would be HP; through innovation in the 1990s, their market cap grew from $9 billion to $153 billion. However, the company decided to stop innovating and maximize profits when a faction led by Patricia Dunn took control. Patricia Dunn used to work in Wells Fargo, and her background is in banking and not on technology. With the focus shifted back to being a watchkeeper rather than innovation, it is no surprise that by 2012, the market cap fell back to $23 billion.
Doesn’t Take into Account the Management Of The Company
The value investor tends to focus too much on the numbers. Most fail to understand that although a company is a cash flow generating asset, it is just a collection of individuals. The people are the ones who run the company, makes decisions daily, which ultimately affect the profitability of the company. Instead of purely looking at numbers, studying interviews of their higher management and how they retain top talent might make more sense. Future profits are only possible if the people in the company make the correct decisions today.
Why It Is Important to Analyze Thing from A First Principles Angle
There are two ways in how we acquire knowledge. The first is to understand how things work in the past and apply what we learn to get similar results. In the case of Warren Buffet, things have performed exceptionally well for him in the past. As such, many investors think that by doing and applying what he did, getting similar results is a guarantee.
However, learning from analogy may be fundamentally flawed because we may not fully understand all the factors at work that affect our results. As such, thinking from First Principles is crucial. This is no different from real estate. For example, purchasing an under-valued property might be fundamentally flawed. This immediately tells you that this is a property that nobody wants right now. It would have been sold for at least at market value if someone else were interested.
Instead of looking at the perceived price difference and dreaming of the profit you might earn in the future, it would be prudent to ask yourself a few questions like these.
What is the main reason why nobody wants to purchase this property?
How many transactions take place in the area?
Why would anyone in the future pay a higher price than what you paid for it today?
Are there any other triggers that will push prices up in the future?
Paradigm Shifts Are Important
Although value investing gives you an indicator of what the company is priced at, it does not reflect what will happen in the future. A valuation model that considers future expected sales, margins, total addressable market, and execution would be far more relevant to make better decisions. And yes, this is why I completely agree with Ken that the decision to take valuation at face value can be dangerous and downright risky. The same thing applies to real estate as well. I hope you find this article useful and give you a better perspective of looking at things. Meanwhile, stay safe and invest safe!
Article contributed by Jerry Wong.
Jerry Wong is a realtor with Propnex Realty. He loves coffee, cookies and condos and has been in real estate for ten years. Most importantly, he loves connecting people to properties and gets enormous satisfaction when they acquire their dream home. Or making well-informed decisions that see their assets grow. Book a video call appointment, and Jerry will share with you the following.
- How certain factors affect real estate prices. Why some condos can make a million dollars while others can lose that same million.
- Why timing is not the most important thing. Because some people can buy the same condo at the same time, but one end up making $100k to $200k while the other suffers losses of the same amount!
- Understanding your requirements and craft a solution for your real estate needs. Be it in asset progression, tax planning, financial calculations, rentals, sales, etc.
You can also subscribe to our Facebook page and receive the latest real estate updates in Singapore!