Value Investing in a Turbulent Economy

By William Shopoff

 

 

 

August 19, 2011

(Irvine, CA)

 

Frequently I try to take some time to sit back, evaluate the business, political and economic climate in which we operate, and determine my view of where we stand and what actions will produce the most favorable results for The Shopoff Group and our clients.

If, after reading this, you share my opinion that we may actually be in a period that has some unusually attractive investment prospects, and you would like to hear more about investment opportunities at The Shopoff Group for Accredited Investors, please contact us.

Current Situation Overview - It has been difficult to ignore the recent headlines highlighting the extreme volatility we have witnessed in the United States and worldwide financial markets. In a recent 4-day period, the Dow Jones Industrial Average alternated losses exceeding 600 and 500 points with two gains of more than 400 points!

Does anyone really believe that values dropped and climbed so dramatically and quickly? It is very easy to have concern when we see the DJIA fall over 16.7% from its 52-week high, including an 11.7% decline in just the first 10 days of August. These figures of course reflect a troubled economy and serious issues resulting from our dysfunctional Washington leadership and legislators.

We recognize that high unemployment correlates strongly to weak new car sales and even worse single family housing starts and sales. By taking a quick peak back in recent history, we can really understand how serious the unemployment situation is now.

Certain segments of the population have suffered disproportionately, most noticeably the double digit unemployment rates of teenagers (aged 15-19) at 25.0% in July, 2011 and Blacks at 15.9%.

 

• Over 6 million Americans have now been unemployed more than 6 months, and the average length of unemployment, which was in the 12-20 week range from 2001-2008, is now over 40 weeks.

 

While unemployment rates ranged from 4.2% - 6.2% during the January 2001 - September, 2008 time period, they have now been above 9.0% every month since May, 2009.

Government stimulus programs failed to create new jobs as total employment has hovered around 139 million for the past 16 months, a level that was first reached as far back as June, 2004, and we are now 7 million below the peak employment figures of late 2007, while our population and work force have grown.

Consequently, the economy remains in a down cycle, albeit in recovery, led by continued weakness in the automotive and housing industries.

• New car sales, while up slightly from 2009 levels, are still 25% below average 2001-2006 unit sales results.
  
  
• Annualized single family housing starts exceeded 1 million units each month from April, 1995 through July, 2007, peaking at 1.8 million units in January, 2006.
  
  
• June, 2011 annualized single family housing starts of 453,000 units were a mere 25% of this peak level, and it has been almost 3 years since starts exceed 600,000 annualized units in any month.
  
  

Clearly, employment figures need to improve in order to stimulate these key sectors and help lead us out of our economic doldrums.

Now you may think that is a lot of bad news. Actually, we see a much brighter side to this current situation. In fact, the low level of current housing production is key to getting the housing market back in equilibrium. Based on current home construction, we think the current over supply will in fact become a severely under supplied market in the not too distant future. This should lead to higher prices for houses and the underlying lots. We cannot be certain of a date this occurs, but are comfortable with our long range model for increased values.

A Look Back - Much of the current news and the prevailing pessimistic feeling that we are bombarded with each day in the media is just what I heard on another occasion prior to a period of great opportunity. In the late 1980s, our country was embittered by a crisis in the savings and loan industry, which became a threat to the United States financial industry. The Resolution Trust Corporation (RTC) was formed in 1989 to liquidate real estate assets including mortgage loans resulting from this crisis. In 1992, I co-founded Asset Recovery Fund with the express goal of investing in foreclosed properties and defaulted commercial mortgages acquired from the RTC. Our firm then acquired, operated and disposed of properties in more than 20 states. These properties included office buildings, shopping centers and several thousand acres of land investments. Our experience with these assets was quite successful, and many of our clients benefited from the above-market returns on these investments.

Value Investing - For many years I have been a disciple of the investing principles practiced by Warren Buffett, and look forward to reading each year's Berkshire Hathaway Annual Report. The primary thing that I admire about Buffett and his chief lieutenant Charlie Munger, is their ability to stay focused on the philosophy of value investing. There are some important lessons to be learned in studying the value investing concepts, and applying them to our real estate investment business. Recently I re-read a favorite book of mine, Seth Klarman's Margin of Safety, Risk Averse Investing Strategies for the Thoughtful Investor. This is a value investing classic written by the founder and president of The Baupost Group, a Boston-based investment partnership that managed in excess of $20 billion of 2010 (and that we have had the good fortune to partner with on three separate ventures). I have written down some of the key thoughts from my readings of Buffett and Klarman, combined with my own beliefs which apply to our country's current economic situation and our business philosophy at The Shopoff Group.

 

 

Hopefully this will help you understand what Value Investing is, and importantly, how you can benefit in today's economy.

 

• While growth investors look for emerging companies with high projected growth rates, value investors look for distressed assets that are trading at a considerable discount from the determined or believed true value of an asset.

 

• Value investors want to determine the Intrinsic Value of an asset, which is their belief of the actual value based on the ability of asset to generate future earnings. This actual or intrinsic value is neither book value nor market value.
  
  

 

As part of our evaluation process for each potential investment, The Shopoff Group examines a myriad of data and projections. For land projects we look at housing needs in our markets over the next few years to help determine projected levels of new housing requirements. We work with experts to determine timing for development in specific geographic areas along with current and anticipated land values. We consider the local political climate and discuss proposed projects with the government entities involved to help determine the likelihood of gaining desired approvals. We apply similar comprehensive analytical techniques to other assets, typically developing detailed business plans and economic outlooks for multiple scenarios regarding the eventual operation and sale of the asset.

 

• Value investing is the discipline of buying assets at a significant discount from their current underlying values and holding them until more of their value is realized. The element of bargain is critical to the process. The asset must be a good absolute value. It is not just about looking for the best value in a group of potential investments - sometimes a value investor will review in depth a great many potential investments without finding a single one that is sufficiently attractive to justify putting their capital to work.

A central tenet of value investing is that over time the general tendency is for the underlying value to be reflected in price. Many of the forces that cause asset values to depart from underlying values are temporary. Long term the price will move toward underlying value with the potential of profit for the value investor.

 

• Market downturns such as what we are presently experiencing are seen as opportunities to buy a great asset on sale. The most beneficial time to be a value investor is when the market is falling. When bad news exists and pessimism reigns assets sell at less than their underlying value, and there is opportunity to take advantage of this irrationality. As the prior economic review indicates, this certainly seems to define the present situation.

 

Klarman states that "when prices are generally falling, fear of loss causes investors to focus solely on the possibility of continued price declines to the exclusion of investment fundamentals." Value investors look for mispriced or under priced assets as determined by some form of fundamental analysis. We are looking for assets that are going through difficult periods or tough times. We want to invest in outstanding assets at good/great prices.

• Being a value investor usually means standing apart from the crowd, challenging conventional wisdom, and opposing the prevailing investment wisdom. Value investors are by nature, contrarians. We have to be willing to take action, to invest, when the masses are moving in the opposite direction.

 

• Value investing is predicated on the fact that the markets are not efficient (or accurate reflections of value). The forces of supply and demand do not necessarily correlate with value at any given time. Investors must look at the future value of an asset.

 

• Investors should pay attention to not only whether, but also to why an asset is undervalued. This is why we focus heavily on the due diligence process prior to making any investment at The Shopoff Group, with extensive reviews of environmental site assessments, insurance (title, fire, casualty and liability), loan documents and guarantees.

 

• While unsuccessful investors are dominated by emotion and the "noise" in the media, successful value investors practice the tenets of Discipline, Patience and Good Judgment.

 

• Wall Street is marked by huge gyrations, a short-term perspective, and is full of fads - it is often hard to distinguish an investment trend from a real business trend. As we have witnessed, stock prices do not move in a predictable fashion, but fluctuate unevenly over time. A price rise does not mean as asset is "performing" well or that the price is justified; likewise, a price decline does not necessarily reflect adverse business developments or value deterioration.

 

 

For me, there is way too much short-term focus - that is not how Olympians train or how you build success toward reaching long-term financial goals.

 

• Value investors pay attention to risk, not just return. They are interested in the preservation of capital. In determining a purchase price, the discount or "margin of safety" allows rooms for such factors as miscalculations, imprecision, market downturns, and changes in credit availability, or even bad luck.

 

Klarman believes that the actual risk of a particular investment cannot be determined from historical data, but depends on the price paid in addition to other factors that cannot be precisely predetermined. While it is not possible to precisely quantify risk ahead of time, but we can take steps to manage risk by:

 

1. Diversifying adequately, and

 

2. Invest with a margin of safety - this is why we try to invest at a discount...to provide a cushion for when things go wrong and to increase returns when things go right!

 

In addition to practicing Value Investing, at The Shopoff Group we also work to add value to each investment. For land projects this is often accomplished through the entitlement process, where we prepare an asset for its highest and best use by gaining the necessary zoning and land use permits, design, road, utility and environmental approvals. It is during this stage that we use our experience and contacts to dramatically increase the land value by removing barriers to development of the property. With other assets we add value through a variety of marketing techniques, change in management, or capital investment to improve the marketability of the property.

 

 

As is often said, you make your money on the "buy." One tenet of value investing is to not be concerned about short term pricing that may move lower. In fact, that presents additional buying opportunities if you have comfort in the long term value properties. That is our focus today and will be into the future.

 

 

 

 

 

 

If you have any questions about this article, please contact the Shopoff Securities, Inc. Investor Relations Department.

     Steve Shopoff (sshopoff@shopoff.com; 214.693.9228)
     Sean Duran (sduran@shopoff.com; 949.417.4409)

 

 

This article contains the current opinions of the author and The Shopoff Group and is made available for informational and educational purposes. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Forecasts, estimates, and certain information contained herein are based upon economic research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.

Past performance is not a guarantee or a reliable indicator of future results. Investing in the real estate involves a high degree of risk, including the possible complete loss of your entire investment. In addition to being an illiquid investment, real estate investments are subject to certain risks including market, interest-rate, credit, and inflation risk.

Securities offered through Shopoff Securities, Member FINRA/SIPC