Access Wealth Strategies

(Author note: I wrote this post at the beginning of 2010 but it got lost in pending status until now.)

Every year, I see magazine articles or major websites that offer their best tips and strategies for the new year. Thus, I’ve decided to share my thoughts as well.

During this global “Great Recession” and related credit crunch, there are historic numbers of distressed assets on sale, and that includes more than just real estate.

Warren Buffett was talking about how great an investment distressed assets were back in 2008. In fact, he would buy them because he knew the long term value was higher than the current impared pricing. Listen to Buffett talk about what he would buy as much as he could in this video below.

The options available to Buffett are one thing, but what options are available to the rest of us?

• Perhaps you are a business owner who currently lease your store or shop space, then there are likely buildings you could purchase that could cost less than your current rent payment.
• If you want to invest in real estate, there are a variety of options. Certainly buying homes from wholesalers or the trustee sale auction is not too difficult.
• A more complicated deal would be to gather some investors to buy performing or non-performing real estate loans at a discount. The numbers I’ve seen are that non-performing loans are selling for 30% of face amount and performing ones are selling for 60%. If the loan ends up performing then you get a good return. If you have to foreclose, you may end up with a great return.
• Paper assets are also on sale. Earlier in 2009, stocks certainly crashed down to levels not seen for a decade. They could fall again.
• How about buying a business from an over-extended owner who needs to raise cash? Make sure it’s a business you know very well and want to own.

A very experienced businessman once told us he’d seen 3 different real estate cycles in the Phoenix area over 30 years.  During the prior cycle he saw people who drove in to town in a pickup truck and a decade later, flew out in their personal Lear jet. They had made millions from buying and selling real estate assets during the market downturn and subsequent rebound.

That’s the cycle we are in now.  What do you think about it? How are you going to capitalize on it?

In the first post of this series we looked at when to buy and sell: Buy when fear is rampant and sell when greed reaches all levels of society in the current market.

In the second post of the series we looked at what to buy.

Buffett already tells us to use price fluctuations to our advantage with the following quote:

Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.

So, how do we know when is the right time to buy and sell? What do the prices look like?

In general a long up-trend will end after asset prices are above the long-term valuation by a standard deviation or more.

Here are 3 good examples from recent experience:

• The technology-driven Nasdaq stock market peaked in March 2000 with the PE (price to earnings) ratio reaching 264 while the more mature Dow 30 index peaked at 42 when the 100-year average is only 14 to 21. In these cases people were paying a very high price for not very much earnings.
• During the residential real estate bubble which peaked in 2005, home prices in some bubble markets had climbed to twice their traditional price to rent ratio. Essentially prices doubled but rents stayed the same. This is unsustainable in the long term because people would eventually choose to rent when they can save so much money each month.
• During the commercial real estate bubble that peaked in 2007, the cap rates had fallen so low that instead of a traditional 10% cap rate, many markets were priced at a 7% or 8% cap. Some coastal markets were even in the 3-4% cap rate range. This was a time when interest rates were rising even above the cap rate — that implies the buyers were banking on appreciating prices only, not current cash flow.

Here’s an example from personal experience. In 2006 I owned some lower-end mid-tier quality rental units in the Dallas/Fort Worth area of Texas. The tenants earned about $25,000 per year and paid around $600 per month in rent.

In early 2006, one of my tenants mentioned to me that she wanted to start flipping houses! This was a clear sign that the last possible buyers had entered the market and the only place for the real estate market was to go down (which it ultimately did starting in 2006).

In case you are wondering, I already had this property for sale and fortunately it sold in March 2006 before the complete collapse of prices.

The summary of the past three articles in this series is to buy quality assets below their long-term conservative valuation at a time when the masses are selling in fear. A good paraphrase of Warren is Buffett to buy value when others are selling it — in other words, the asset is “on sale”.

You may also find these Motley Fool articles interesting:

• Warren Buffett’s Best Advice Ever
• Everything Buffett Needs to Know, He Learned Right Here.

In the first part of this series, How to Invest Like Warren Buffett: Fear and Greed we looked at when Buffett makes his purchase. He does so at the opposite time of most amateur investors, when an investment isn’t the most popular and in fact when it is probably out of favor.

One good example was Buffett’s multi-billion dollar investments in Goldman Sach and General Electric during the market meltdown in late 2008. At a time when it wasn’t clear that the financial system would survive, he invested billions of his cash in quality companies that were unpopular at the time.

After looking at when to buy, the next logical question is what to buy.

Warren Buffett has some simple principles that he uses to determine what to buy. The first is to buy quality and in fact a quality company that he could hold forever (he says his favorite holding time period is forever).

So, what are the components and characteristics of a quality company?

1) A simple business model that Buffett says that he can understand and that will be roughly the same in 10 years or more.

• This business must have an economic moat of some sort that keeps out a plethora of competition. This moat allows the company to earn a high return on equity.

2) The company must produce consistent cash flow — this characteristic follows from the first above. Buffett is talking about real cash flow, not just theoretical earnings based upon extending generous terms or loans to the customer to buy the product or service.

• An example of “faking” cash flow would be Lucent Technologies, which, during the tech bubble of the late 1990′s, inflated their book earnings by selling to customers through credit terms which the customers could not repay. They also manipulated their financial statements to report better numbers than were true.
• Buffett would reject investing in a company like Lucent because the business requires constant innovation, it was sufficiently complex that the true financial health could be hidden by financial chicanery, and there was not cash flow, just paper profits (which never materialized).

3) A management team that can be trusted.

“When hiring, you look for three qualities: integrity, intelligence, and energy. And if you don’t have the first, the other two will kill you.”

• A management team without integrity is very likely to put their personal priorities ahead of the business’s which will ultimately lead to disaster for the company.

A summary for the concept of what to buy is contained in Buffett’s quote below:

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price,” because “time is the friend of the wonderful company, the enemy of the mediocre.”

Warren Buffett’s returns prove that he is the greatest investor of all time. Can we invest like him and achieve similar results? If so, how can we invest like Warren Buffett?

Fortunately, Buffet’s own words provide plenty of clues from which we can derive his main investing principles.

One of Warren Buffet’s most well known quotes is:

We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.

Sounds simple enough. We should then buy when others are selling or sell (or at least don’t buy) when everyone else is buying.

Some obvious examples from the past decade to guide our thinking:

• Would Buffett be buying tech stocks in 2000 when they were richly valued and in the news daily? Or would he wait until 2002 to buy them when many tech companies had failed and those that survived were selling for little more than the cash on their balance sheet?
• How about real estate, would Buffett be buying condos and new construction homes in 2006 with an abundance of flippers and sub prime buyers? Or would he wait to buy distressed properties from the banks in 2009?
• Finally, would he be buying oil stocks in 2008 when oil peaked near $150 per barrel? Or would he wait for oil prices to crash after the recession started?

Well, it turned out Buffett made a mistake – proving that no investor is perfect and that they don’t have to be perfect to amass high returns. Buffett did accumulate up to 84 million shares of ConocoPhillips (COP) by the third quarter of 2008 just at the peak of oil prices. He has since admitted his mistake and sold his position.

In conclusion, we can use Buffett’s simple rule to buy when others are fearful (selling) and sell when others are greedy (buying). Do the opposite of the popular thing. This principle applies to any asset class.

A good test might be to ask 10 people if they are buying an asset currently or considering doing so. If more than 5 say yes, then perhaps it might be worth looking elsewhere. On the other hand if only 1-2 of them say yes, then you might be on to finding an undervalued asset. As a corollary if 8 or more say yes, the potential for a price bubble is very high.

What asset class appears unpopular to you currently? Does any asset class seem too popular right now?