In a recent blog post I listed the 23 winning investment habits of Warren Buffett and George Soros as identified in his excellent book by Mark Tier.
Although in many respects equities and real estate present very different challenges.
In today’s blog I’ll take a brief look at what parallels property investors might be able to draw from the psyche and investment approach of the world’s most famous and successful investor.
It’s fairly well known that Buffett seeks out value, he prefers to go long and hold for the long-term, all of which are of course sound strategies.
But if we dig a little deeper, what else can we learn?
Buffett’s mentor was the legendary value investor Benjamin Graham, who espoused his theory of buying shares in companies at a margin of safety to their intrinsic value.
In particular, Graham often looked at companies which had fallen upon hard times and sometimes sought companies which were trading at a significant discount to their book value or net assets.
His theory was that even in the event of such companies being liquidated there should still be a positive result for the investor.
This is known as “cigar-butt” investing where the investor hopes to get “one last puff of smoke” out of the ailing asset.
Buffett’s great skill was having the foresight and the confidence to model or learn from Graham yet apply his own updated and modified approach.
Buffett still considered the margin of safety to be of vital importance but moved away from price-to-book and placed far more emphasis on the future growth prospects of a company.“Time is the friend of the great company and the enemy of the mediocre.”
Property investors definitely need to demonstrate the ability to move in tune with the shifting landscape.
So much has changed in Australia in recent decades that the strategies that may have worked in times past could almost guarantee failure today.
What has changed specifically?
Lending practices are markedly different.
Inflation has been significantly lower for around two decades now.
Household sizes are smaller and more Australians elect (or are forced by declining affordability) to choose medium-density dwellings.
Demographics have shifted and the quarter-acre plot in the middle-outer suburb is no longer so often the property type of choice.
As for “cigar-butt investing” in bargain-basement regional US properties…each to their own, but it’s not a strategy for me.
One of the surprising aspects of Buffett’s approach to many is that he has not tended to seek out smaller or unknown companies that nobody else could have thought of investing in.
Even if he wanted to, the vast size of Berkshire’s capital would preclude him from investing in too many secondary issues today.
Instead, Buffett has invested in huge global brands such as Gillette (razors) and Coca-Cola (erm, Cola), and more lately Tesco (supermarkets) and IBM (software and computing equipment).
In fact, IBM is a great example - a market darling of yesteryear, Buffett has waited for decades for the price to become attractive before placing a huge multi-billion dollar bet on that company.
Buffett likes to seek out “franchise companies” with near-monopolies which supply goods or services for which there is a constant need or cannot easily be replaced.
In today’s era of higher household leverage investors in property would be very wise to focus on quality suburbs and quality established properties which are in continual and very high demand.
Chasing yields in areas of lower demand could be a risky approach as evidenced in some overseas markets.
Buffett pays close attention to company remuneration reports.
He has disdain for companies which are run for the benefit of management and which pay outlandish bonuses.
In particular Buffett keeps a watchful eye on companies which issue millions of stock options to the executive.
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Stock options when converted or exercised dilute the common stock or the value of ordinary shares held by investors.
Naturally enough, Buffett detests this.
Dilution of value is a salient risk in property investment.
With the shift towards smaller household sizes, established apartments and townhouses can make for outstanding investments in the right suburbs.
However, there is a risk in some areas that large new developments flood the market with new supply which reduces the scarcity value of existing stock.
Areas which are particularly at risk of dilution include CBDs or suburbs with few height restrictions on buildings, but also suburbs which are not landlocked and have land potentially available for release.
Price corrections can be sharp where large new developments make available properties ten-a-penny, so property investors need to do their due diligence and proceed only with caution.
Buffett seeks companies which have the potential for sustainable growth from within, rather than those which tend to ‘grow’ through acquisition.
Hence, Berkshire places emphasis on a range of ratios including P/E and ROIC rather than focussing purely on earnings and earnings per share.
EPS can increase where a company finances even suboptimal projects purely through debt, and Buffett hates excessive levels of debt.
There is a clear parallel with residential property here.
The structural shift towards lower interest rates which has played out over the last two decades has resulted in households borrowing higher multiples of income than was previously the case.
Although it may seem otherwise after the explosion in credit and property prices over that time, property price growth cannot be fuelled forever simply by all households taking on ever greater mortgage stress and ever more debt.
Property is ideally suited to being a long-term investment and investors should not be deceived into thinking that it is a one-way bet.
To have any realistic hope of outperforming over the long haul, investors should seek out urban areas and suburbs which will show real and sustainable household income growth for decades to come.
I know of no better way than to follow demographic trends and look to major financial centres.
The population is booming in four of our major capital cities.
Just as was witnessed in the case of IBM, Buffett likes to identify quality companies with outstanding long-term prospects and then wait for his time to strike.
Never was this better demonstrated than Berkshire’s $1 billion investment in Coca-Cola.
With around a century of earnings history for Buffett to analyse, he knew that Coke had an almost unbreachable brand moat and waited for his moment to pounce.
Cola is a very cheap product to produce but it is very difficult to compete with Coke and its gargantuan advertising budget as Sir Richard Branson quickly discovered with his Virgin Cola brand.
After the disastrous launch of the “New Coke” product which simultaneously confused and repelled customers, the stock market also suffered a tremendously sharp yet short-lived meltdown in the famous 1987 crash.
Within a remarkably short period of time the $1 billion investment had grown to a market value of $13 billion and came to represent around 40% of Berkshire’s entire investment portfolio.
Buffett knew that this was his time and bought very heavily.
Seasoned property investors often look to profit from a similar approach.
Australian capital cities experience property market cycles but prices rarely tend to move contemporaneously.
Melbourne, for example, has shown tremendous price growth through what has been a lean period for Brisbane.
Experienced investors aim to learn to recognise such cycles and acquire property after a prolonged lull in price growth while always remembering that over the long term quality is the key to success.