Charting The Course
The Secret of Life – Just One Thing
By Mitch Siegler, Senior Managing Director
In the 1991 comedy City Slickers, aging cowboy Curly Washburn (the late Jack Palance) gave Mitch Robbins (Billy Crystal) some great life advice.
Curly: “Do you know what the secret of life is?” [holds up one finger] “This.”
Mitch: “Your finger?”
Curly: “One thing. Just one thing. You stick to that and the rest don’t mean shit.”
Mitch: “But, what is the ‘one thing?’”
Curly: “That’s what you have to find out.”
Successful investing requires careful attention to a great many details – investment thesis, entry point, holding period, changes in market conditions (economic circumstances and capital markets), exit point and strategy – all at the same time. Take your eye off the ball of any one of these and you’ll likely not be too pleased with the results. (Or as Curly might have said, “Don’t squat with your spurs on.”)
If Curly were here today, we think he would agree that the holy grail of investing is spotting opportunities to achieve asymmetrical returns – those rare situations where the potential upside exceeds the potential downside. Many people express this in terms of seeking “downside protection”. At Pathfinder, it’s an ongoing and intense search for value – what we and others call “value investing,” which we generally pursue by adding value (we call this a “value-add strategy”).
In traditional equity and fixed income investing, a dividend or bond coupon can provide not only income but also downside protection for the investment. Stocks of companies with bullet-proof balance sheets (those that are asset-rich, low in debt or both) or with strong brand positions can also deliver downside protection. In real estate investing, properties in improving cities or neighborhoods and those which haven’t been upgraded recently (e.g. those having “value-add” potential) can create an opportunity for the owner to raise rents and “manufacture” higher income, creating the potential for asymmetrical investment returns.
We believe that the only true way to “make money on the buy” or add substantial value to a property is to view it through a different lens than others. Only if your judgments are superior is your performance likely to be above average. As Curly said, trying to find that “one thing”.
For Howard Marks, that one thing is second-level thinking. Marks, Chairman and CEO of Oaktree Capital Management, a private equity firm with $100 billion in assets under management, describes first-level thinking as “It’s a good company; let’s buy the stock.” Second-level thinking says “It’s a good company, but everyone thinks it’s a great company, and it’s not. So the stock’s overrated and overpriced; let’s sell.” In highly efficient markets like stocks and bonds, millions of investors work each day to evaluate each new bit of data and parse every piece of information – as a result, prices immediately reflect the consensus view of the available information. The largest securities markets can be so efficient that it’s generally a waste of time for ordinary mortals to hunt for inefficiencies (read “winners”) there. It’s a little bit easier in mid-cap securities and easier still in small-cap securities or emerging markets – where the institutional ownership is thinner and analyst coverage is spottier. That analogy extends to other asset classes, like real estate, where you can’t look in the newspaper (or Google) for the price on a minute-by-minute basis. And, as you venture further from the large properties and gateway cities, opportunities to find inefficiencies and value grows for many of the same reasons.
Marks says “first-level thinkers see what is obvious.” To be extraordinarily successful, “you must bring exceptional analytical ability, insight or foresight. But because it’s exceptional, few people have it.” We believe second-level thinkers know that, to achieve superior results, they must have a different strategy, an edge in either information or analysis, or a combination. Having a nose for mispriced assets or opportunities which are hidden from view is the essence of second-level thinking. Why should the opportunity for a bargain exist in an environment where thousands of investors are champing at the bit to bid up the price of anything that’s too cheap? For Pathfinder, a differentiated and focused strategy, one that is continuously improving, is a pretty good summary of second-level thinking.
Now, while the consensus view in markets is not always correct, Pathfinder’s space – small balance real estate – is fragmented and not as efficient as the market for large properties or those in gateway cities – and nowhere near as efficient as the market for stocks and bonds. It’s that inefficiency that creates the potential opportunity (certainly not guaranteed but more of a possibility in a more inefficient environment) to buy an asset for less than its true value. Since you can never count on some yahoo coming along who will buy your asset from you for more than it’s worth, the most reliable way to make money in the long-term is to buy assets for a discount to their true (or potential) value. Buying at a discount to potential value and then creating value – or having the asset’s price move toward its true value – isn’t dependent on blind luck, good fortune or that yahoo coming along – it just requires that your value creation impact the asset’s cash flow or that other buyers in the market eventually come around to your point of view about the good things happening in that city or neighborhood or property type.
Sure, buying a property that hasn’t been upgraded, or in a neighborhood that hasn’t yet gentrified or with litigation or other “hair” appears at first blush to be risky. But if you’ve done your homework and have true conviction about the investment, those risks are meaningfully mitigated. And, as a bonus, you’ve bought the property more cheaply than if there wasn’t “hair” – so there’s downside protection and the possibility for much greater (asymmetrical) returns if you’re correct. Low price can reduce risk and increase returns while high price can often increase risk and lower return. (Or, as Curly might have said, “Never ask a barber if you need a haircut.”)
We’ve observed that many large institutional investors must, by necessity, impose constraints on their activities, which can sometimes impede second-level thinking. Mega-firms need to write mega-checks so they’re essentially precluded from making smaller investments (thresholds are $25 million for many groups and for some $50 or even $100 million; similarly, many firms won’t buy apartment complexes with fewer than 100 units, opening the door to others for a less crowded field in the world of 75- to 99-unit apartments). And, in environments where opportunity exceeds available capital as in 2009-2012, it’s easy to be choosy and exclude troubled geographies from the target map (the Inland Empire, Las Vegas and even Phoenix were red-lined by many firms until recently).
Capitalization also impacts the competitive landscape – as the majority of banks won’t lend on partially-sold (aka “fractured”) condominium projects or properties with unresolved environmental issues or construction defect litigation. So, many equity investors are unable to invest in these types of properties since their returns are predicated on a certain proportion of debt in the capital stack. Second-level thinkers exploit these opportunities, resolve these issues and often are able to do so in an environment with less competition. Many of the best bargains at any point in time are found among the things other investors can’t or won’t do. It’s counter-intuitive but the safest and potentially most profitable thing to buy is something no one else likes. Given time, its popularity (and price), will tend to go up. See what others don’t. (Or, to paraphrase that great American philosopher and ballplayer, Yogi Berra – who Curly certainly would have liked – “Nobody ever goes to that restaurant anymore – it’s too crowded.”)
Which brings us back to second-level thinking – here are a few strategies for improving your second-level thinking:
Rule #1 – Be humble. Examine both sides of the argument or investment stance. Seek out opinions that vary from your own. Consider that you could be wrong – it demonstrates intellectual honesty and the self-awareness that comes from having made (and learned from) your mistakes.
Rule #2 – Think about investment decisions in terms of probabilities, never absolutes. Things are rarely black and white – generally, they’re grey.
Rule #3 – Consider psychology and anticipate the expectations of others – markets often rise and fall more based on expectations than about fundamentals, especially in the short- to intermediate-term. It’s not always about things getting better or worse – sometimes it’s about change, the pace of change, a bit less bubbly or a little less terrible.
Rule #4 – Maintain focus and remain disciplined. Evaluate your decisions not based on their outcomes but rather by the process (ideally, one that is disciplined, comprehensive and systematic) which you took to make them.
Rule #5 – Always consider the difference between price and value. Any security or property can make for a good investment at one price and a poor one at another.
Rule #6 – Remember Rule #1. Be humble. Never become too confident in your own abilities. (Or, as Mark Twain – another fella Curly would have enjoyed –
said: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”)
Best wishes, pardner, for a wonderful 2016.
Mitch Siegler is Senior Managing Director of Pathfinder Partners, LLC. 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.