Avoiding Investing Trolls
Board: Real Estate Investment Trusts
Here is a post I did a few weeks ago for SNL's "Block Party." Most of you are aware of the dangers noted below, but thought I'd post it anyway - as all of us have been snagged at one time or another by the "Trolls" mentioned.
There are, I believe, basically two kinds of investment objectives: (1) obtaining satisfactory returns on capital deployed, and (2) beating either a benchmark or the other guys who make similar investments. The dynamics and strategies of each such objective are very different. In this Block Party post I’d like to share some of my thoughts about the former. Next time I’ll offer a few observations on “performance derby” investing.
How difficult is it to get satisfactory investment returns? I’ve been playing this very serious game for about 45 years, during which I have enjoyed the thrills of bull markets and suffered the agonies of bear markets. I have learned that obtaining satisfactory results isn’t difficult – but only if one can avoid a number of evil trolls that seem to lurk behind every bridge. Let’s look at a few of the most dangerous of these creatures, many of whom have given me a real butt-kicking in times past. Only by being able to recognize and avoid most of them can we generate adequate returns. And I say “most” with good reason, as no one – not even Warren E Buffett – can consistently avoid all of them.
The Emotional Troll. The limbic portion of the brain is associated with our emotional responses to external stimuli; the impulse towards “fight or flight” is as old as the Neanderthal man. When faced with danger, such as an angry pterodactyl or a substantial investment loss, we are apt to cut and run. In the investment world this happens, all too often, at bear market lows. I have learned that there is only one way to avoid this troll: know, as well as reasonably possible, the companies in which we invest. My biggest investment mistakes have come from selling declining stocks of companies that I’d didn’t understand well. About eight months ago, I sold my Valero Energy (VLO) at $39.35 during a scary but short-lived decline; it is now over $55. Only when we really understand what a company is all about, including its risks and potential, will we have the wisdom (and the guts) to hold on tight – and even buy more – when its stock is put on sale. Fortunately, REITs’ businesses are fairly easy to understand.
The Love Troll. It’s also human nature to fall in love with a stock – especially if it’s been good to us. Often this love can be stoked by company management that seems to constantly hit doubles and triples, and we begin to think that these guys walk on water. But some success is due to luck, market conditions always change, and a particular business strategy such as (in our REIT world) property development, may no longer be value-creative. No, we cannot predict the future, but if we don’t fall in love with a stock we are more willing to reduce a position or exit entirely if we perceive that the company’s business strategy may not work as well in the future as it has in the past. Patriot-American (now Wyndham (WYN)), old-timers might remember, was a REIT acquisition machine, and was everyone’s darling – including mine – until that business model no longer worked. Losses were substantial for those who were in love and couldn’t say good-bye.
The Overconfident Troll. Decades ago a very savvy investor, Martin Sosnoff, wrote a book – “Humble on Wall Street.” It still sits on my bookshelf. In it, the author related a number of his “can’t miss” investment ideas, each of which eventually did him in. Overconfidence and its close cousin, hubris, have been the bane of all too many investors. Successful investors need to remind themselves constantly that economies and markets are treacherous places, where Black Swans arrive without notice. These creatures can destroy all our assumptions about specific companies and even entire industries. Did anyone’s REIT investment model factor in a 40% decline in commercial real estate prices just a few years ago?
Insuring ourselves against Black Swans isn’t cost-effective (unless we avoid all risk by investing only in 6-month Treasury bills), but avoiding overconfidence will permit us to continuously look over our shoulders and, perhaps, enable us to react quickly to potentially ominous, or even disturbing, events. And, just as we ourselves should avoid investment hubris, we should be wary of companies whose management teams are guilty of it. REIT world has, unfortunately, had its share of hubristic CEOs. You know them – I won’t name names. Watch these guys very carefully; they may not know their limitations.
Finally, those who can avoid the overconfidence troll may be able to resist the temptation of buying stocks on margin, which can decimate investment returns and induce (or force) us to sell at market lows.
The Guru Troll. I suppose it’s human nature, when facing uncertainty – and the investment world is always uncertain – to look for investment gurus who seemingly know everything. We listen with rapt attention, and buy or sell those stocks in those industries (or property sectors) which the Guru Troll has blessed or cursed. Early in my investment endeavors I, too, fell into this trap – learning eventually that all such idols have clay feet. Robert Prechter, Henry Blodgett, Nouriel Roubini – they all have had their 15 minutes of fame (sometimes longer) – but we cannot rely on any of them to be right more than 50% of the time. The investment world performs as might be predicted by Chaos Theory, and accurate macro forecasts and can’t-miss stocks are as fleeting as the celebrities on the cover of this week’s People magazine.
The Timing Troll. Market timing is deceptively easy. “Buy stocks that are rising,” or “buy stocks that have been beaten down.” “Now is the time to buy (or to sell) REITs.” “Buy companies with earnings momentum,” “sell those that miss their numbers for (fill in the blank) quarters.” “Buy (or sell) when a stock crosses its 90-day moving average.” These are all persuasive theories, but come with a small problem – they don’t work. Instead, buy stocks in companies you like – for whatever rational reason – and sell them only when they meet your price objective or when the reason you own them ceases to exist. To quote that old saw from John Maynard Keynes, “when the facts change, I change my mind. What do you do, sir?”
The YieldHog Troll. This troll, who often frequents REITville, is insidious. He tries to persuade us that there is a free lunch in the investment world, which comes in the form of very high dividend yields. Most of us like to have current income from our equity investments, along with price appreciation. But some investors become obsessed with high yields, and fail to appreciate the risks that are almost always inherent when a stock (or bond) pays a current yield 600-1,000 bps above 10-year Treasuries. These investments appear in various wrappers, including gamy junk bonds, some master limited partnerships, even many mortgage REITs. But extraordinary yields come with extraordinary risks, often including lousy balance sheets (including crazy-high debt leverage), potential disruptions in company cash flows, fluctuating commodity prices, and highly aggressive and/or unsustainable business strategies.
The rule of thumb here is a simple one: If a dividend yield is too good to be true, it probably isn’t true. We can quickly lose in investment value a lot more than we gain from extraordinary current income. If a 10% yield floats your boat, feel free to jump on board – but recognize that it is likely, in the not-too-distant future, to capsize.
Those, I think, are the meanest and baddest trolls. They will snare, at times, even the best investors. I am a long way from being in that category, but I have done reasonably well over the years. I don’t credit any particular investment wisdom for this, but have managed, at least over the past 20 years, to survive the investment wars by avoiding anything worse than occasional scratches and bruises from these guys.
Finally, there’s an even easier way – for those who aren’t cursed with the investment bug – to avoid those trolls. Buy indexed ETF’s or mutual funds, add to them as free cash flow permits, and create a garden, play golf or visit the grandkids.