Charting the Course
2020: Time to Pivot Your Investment Strategy?
By Mitch Siegler, Senior Managing Director
Looking back over the past decade, we see two distinct investment phases and looking around the bend, we’re seeing a third phase taking shape. Investing for growth – a strategy that served investors well at the depths of the equity and real estate market collapse in 2009 – shifted to more of a value investing strategy after the markets recovered in 2012-2014. Now, with values near peak levels for this cycle, investors may be well served with a steady-Eddie, income-oriented approach emphasizing dividend-paying stocks or stabilized, income-generating properties. We’ll cover these two prior phases and point out a few reasons we think an inflection point marking the shift to a third phase may be near.
Phase I, 2009-2014, Growth Investing
On March 9, 2009, the S&P 500 had plummeted to 673, down 64% from its 2007 peak of 1,890. (At press time, it’s 3,093, an increase of more than 350% from the nadir.) In 2009, it was also a buyer’s market for real estate as non-performing loans and bank foreclosures had skyrocketed and the opportunity to buy half-empty retail centers and office buildings, partially constructed condo projects and finished residential lots at deep discounts to the prior owner’s invested capital were there for the taking. Sure, buying anything at that time wasn’t for the faint of heart and there were many twists and turns along the way but investors who took the plunge then did quite well.
Equity investors did best on what to many looked like the “riskiest” stocks; technology companies have been among the best performers of the past decade. Investors who took the plunge buying well-located properties from lenders generally hit it out of the park because their cost basis was so low – they benefited most as markets recovered. The well-located apartment buildings we bought then are today worth double or triple – and the multiple of invested capital on those investments often exceed the above returns on equity investments.
In the early years of this cycle, prices for most assets were so beaten down that it almost didn’t matter what you bought – everything was worth a lot more a few years later. Since the world didn’t come to an end, assets perceived as riskier performed better but everything – blue-chip, value and growth stocks and most properties –
did quite well.
Phase II, 2014-2019, Value Investing
By 2012, markets had turned up dramatically, with the S&P 500 ending the year above 1,400, more than double the March 2009 trough. During the 2014-2019 period, investors in growth stocks continued to have a great run. In fact, the annual return of the growth index from 2014 to 2019 was 13.6% as compared with 8% for the value index. Easy money helped investors take more risks, and they have been rewarded so far for doing so.
For real estate investors around 2012-2014, it wasn’t nearly so gloom-and doom and opportunities to buy foreclosed properties from lenders, were by then, basically nonexistent. Banks had disposed of many of their riskiest properties and the 2009 buyer’s market had shifted to a more balanced market, even a seller’s market, as considerable capital flooded into real estate and the banks, which had stronger balance sheets and far fewer non-performing assets, had more pricing power. By 2014, truly distressed real estate buyers were mostly a distant memory.
Around this time, we shifted from the higher-octane approach of buying partially constructed condo projects, land and commercial projects with high vacancies to acquiring well-located, bread-and-butter apartments and adding value to them. We felt that housing supply and demand were imbalanced, and we were keen to buy existing apartments below replacement cost. We searched far and wide for long-terms owners who really didn’t give their ‘80’s and ’90’s-vintage properties much love and starved them of capital and then we infused millions to transform these properties and dramatically boost rents and income. The strategy served us and our investors well and we think the strategy still has legs. Compared with our brethren in the equity investing world, we played it quite safe.
Phase III, 2019-202(?), Income Investing
As we make our case for why we may be nearing an inflection point and investors may wish to consider pivoting their investment strategy, here are ten observations about the current landscape that informs this view:
- Economic growth is slowing worldwide with some important markets on the cusp of recession. Last month, the International Monetary Fund (IMF) reduced its 2019 global growth forecast to 3.0%, the lowest level since the 2009 recession. The IMF is hopeful that growth will tick up to 3.4% next year. Consider that this is the global average which benefits from China’s strong 6.3% rate and India’s 5.0% rate. Closer to home, the IMF’s estimate for the U.S. is 2.0% with Europe and Japan even lower. If there’s a further slowdown in China, all bets are off. The U.S./European/Japanese growth rates, while better than a poke in the eye with a sharp stick, are nothing to write home about.
- Geopolitical risks remain. Now, there are always geopolitical risks but when you look at today’s list (China/Hong Kong, Turkey/Syria, North Korea, Iran, Brexit, Impeachment Inquiry, etc.), it feels longer than usual.
- Fiscal and monetary stimulus are proving the law of diminishing returns. The 2017 tax cuts boosted the U.S. economy in 2018 but the long-term benefits could be less. Quantitative Easing (QE) – rounds 1, 2 and 3 – could soon be followed by QE4. As the Bank of Japan and the European Central Bank have seen, it’s hard to force credit on those who don’t really want it; increases in the savings rate even with zero or negative interest rates are probably not what central bankers expected.
- The U.S. budget deficit is nearly $1 trillion this year, driven by large military spending and interest on the debt. Since deficits rise as the government increases stimulus during recessions and it’s been more than a decade since the last recession, odds of the deficit shrinking anytime soon are slim – and that’s with interest rates at record-low levels – hold on to your seats should rates rise. And all of this is before we see any of the big-ticket spending plans being bandied about (like universal health care/Medicare for all, free college tuition, reparations, etc.)
- Cracks in the confidence façade are showing up more and more. The Boeing CEO’s 737 Max testimony to Congress in late October makes the aircraft manufacturer’s execs look like The Gang That Couldn’t Shoot Straight. Facebook is being attacked from every direction. The much ballyhooed WeWork IPO collapsed. More “do no wrong” tech unicorns are having challenges raising capital.
- Low/negative interest rates are pushing investors to take on more risk. We’ve all read about Scandinavian banks offering mortgages that require payoffs years in the future lower than today’s loan amount. Or banks paying depositors negative interest rates (e.g., depositors paying the bank to store their money). Last month, Greece issued €487.5 million ($535.31 million) of three-month debt at a yield of negative 0.02%. Even in the U.S., real interest rates are negative. While a saver might earn 1.9% on the highest-yielding money market accounts, that’s small consolation when inflation is running 2.5%-3.0%, meaning real interest rates are negative 0.6% to 1.1%. We don’t pretend to make sense of this Alice in Wonderland stuff.
- Flashing yellow lights: Debt funds and pension funds. During the past decade, as regulators have scrutinized banks to prevent another foreclosure and subprime mortgage-type crisis, hundreds of billions of investor dollars have flowed into unregulated financial institutions operating outside regulators’ purview. Their rates are higher than banks’ and they’ll generally take more risk, allowing second-tier borrowers to push leverage, often on sketchier projects in riskier markets. While we don’t expect many bank foreclosures as they’ve been cautious, debt funds could be a source of distress. When we read about pension funds’ high spending commitments for their retirees and the correspondingly high long-term returns needed to meet their obligations, we scratch our heads. Long-term returns of 7-8% for groups like CalPERS (California Public Employees Retirement System) are – and we’re being as diplomatic as possible here – unlikely – given their predominant mix of equity and fixed income investments, which are virtually assured to see lower returns in the next few years than in the past.
- Fed machinations. In the past year, the Fed has raised rates, then cut them; shrunk, then expanded its balance sheet; injected, withdrawn, then injected liquidity. The Fed has a large budget and some awfully smart people. This behavior doesn’t square with Fed officials being clueless or confused. More likely, we’re at an economic turning point of some sort.
- Negative real interest rates and other relationships that are out of whack. At press time, the S&P 500 dividend yield was 1.80%, near the 10-year Treasury yield of 1.81%. This parity is unusual.
- Other warning signs include high-yield, highly-leveraged and covenant-lite loans, which the IMF estimates exceed $19 trillion. This “debt-at-risk,” from firms whose earnings would not cover the cost of their interest expenses could rear its head in a recession or economic slowdown.
So, in this topsy-turvy environment, we think an abundance of caution is in order. Our investors have been telling us for years they’d like more income and they don’t see opportunities to find it in traditional equities and fixed income. We’re partial to real estate – it’s a hard asset, after all, and comes with tax-sheltering aspects by virtue of depreciation. And, it appears that the supply/demand imbalance we’ve seen in rental housing for the past many years remains firmly in place, especially in markets with strong population and job growth.
For these reasons, we’ve laser-focused our investing strategy during the past few years to apartments in a handful of growth markets. Looking ahead, we plan to hold properties longer and lock-in longer-term, fixed-rate debt – we can borrow for the long haul today at under 4.0%. And, we’re planning to emphasize stabilized apartments, which are throwing off attractive cash flow immediately (5% per year and growing).
At some point, investors will see attractive value and growth investment opportunities again. But there’s a season for everything and we think the season to play it safe and clip coupons (investing for cash flow via dividends or property income) is fast approaching.
Mitch Siegler is Senior Managing Director of Pathfinder Partners. Prior to co-founding Pathfinder in 2006, Mitch founded and served as CEO of several companies and was a partner with an investment banking and venture capital firm. Reach him at firstname.lastname@example.org.