Fundamentals of Sound Investment

By: 
Al Jacobs

Over nearly five decades of involvement in investments, both participating in and observing, I’ve witnessed about every variation imaginable. During this period I’ve also surveyed endless advice and recommendations on the subject. Yet, despite the overwhelming amount of information available, the actual principles of investment are few in number and basic in their application. Generally, if you can cut through the maze surrounding a proposal or offering, the elements upon which its probable success or failure relies becomes easily observable. To this end, I’d like to discuss five fundamental factors governing investment.

1. Consider your Comfort Level. Whatever your selected endeavor, take into consideration your personal abilities and limitations. If, for example, you function well with people in a down-to-earth business setting and enjoy the challenge of making repairs and improvements to real property, you might be a natural in owning and managing apartment units. However, if you consider the prospect of tenant interaction repugnant, and regard property maintenance as a drag, you’ll do yourself no favor by entering the field.

Similarly, if you find a corporation’s annual report intriguing, and eagerly scrutinize analysts’ reviews in the evaluation of public companies (there really are such people), you could find success in building and maintaining an active and profitable securities portfolio. But for those of you who regard corporate securities a bore, or for whom ownership of a share of stock which may decline in value causes mental anguish, you’re probably better off staying clear of the market.

2. Beware of Needless Complexity. Mounted in a frame on my wall is one of the many versions of Murphy’s Law. It reads: “Nothing is as easy as it looks. Everything takes longer than you expect. And if anything can go wrong – it will, at the worst possible moment.” This pretty well spells it out; as matters become increasingly complex, there are more things to go wrong. Therefore, if you choose to purchase subordinated debentures issued by a firm that manufactures and markets highly specialized golf clubs, the safety of your investment will be subject to successful management of the company, competition by other firms, the popularity of golf, and many other variables I can’t even imagine.

By contrast, when loaning money to a homeowner with good credit and substantial home equity, secured by a mortgage on the home, there’s far less uncertainty. As the prevailing theory goes, reward increases with risk, so you’d expect interest paid on the debenture to be far greater than on the mortgage loan. But in real life it doesn’t always work the way you might imagine. For this reason it’s your job in each instance to consider the complexities, analyze the risk, and decide whether the return is adequate.

3. Be Certain the Numbers Make Sense. When presented with an investment proposal, together with a set of figures purporting to show how advantageous it will be, the first thing to consider is whether the numbers are reasonable. Do they seem to make sense?  I’ll give you an actual example. I recently analyzed the purchase of an annual 1-week interval at a timeshare project for a friend, the specific property being a 750 sq ft, 2-bedroom condominium in an outlying resort area in Southern California. The terms: $14,500 price, 20% down payment, monthly mortgage installments $97.90 for 15 years, and $47.50 monthly toward taxes, insurance, maintenance, and supervision. Although my friend could easily afford the $2,900 down and $1,745 a year carrying cost, I pointed out an identical unit at the resort rented at a daily rate of $125. Why purchase if the cost of a week’s rental stay is only $903, with no initial investment or mortgage burden?

To conclude my argument I quickly calculated how, with buyers for each of the year’s 52 weeks obtained under the same terms, the timeshare association receives $754,000 in sales revenue plus $29,640 in annual payments for the single unit. Adding insult to injury, similarly sized condominiums a few miles away garnered a market price of only $195,000. As you might guess, my friend expressed no further interest in the project.

4. Identify the Source of Profitability. If anything constitutes the heart of an investment, it’s the reasonable assurance it will generate a benefit of some sort over a defined period of time. In the case of corporate stock, this is the systematic payment of a dividend and/or appreciation in share value. For the ownership of commercial real estate, it means an expectation the property will generate a net cash flow as well as experience some value enhancement. You should note the basis for value is not the benefit generated, but rather the reasonable assurance of this benefit. This may seem illogical, but it’s significant. In each case, value is determined by careful analysis of the underlying operations.

To make the point, even though a lottery ticket may pay its holder a fortune, it possesses no definable value. There can be no reasonable assurance it will deliver anything. And yet it’s this gambling mentality which often takes charge in establishing whole industries. As a striking example, consider America’s technology firms in the years leading up to their 2000 collapse. Many of those companies experienced phenomenal increases in common stock price, despite the fact they neither generated income, produced viable products, nor offered future promise. No reasonably anticipated benefits existed; any value relied on pure speculation.

By contrast, as I began purchasing previously foreclosed-upon condominiums in 1995 from banks and government agencies in then-bankrupt Orange County, California, the rental market generated an annual 16% return on the less-than-replacement-cost purchase prices. Whether or not the properties might one day appreciate in value seemed almost unimportant; the predictable cash flow return justified any long term risk. It worked nicely and the six-fold increase in market value over the following ten years, almost an afterthought, proved to be massive frosting on the cake.

5. Arrange for Adequate Security. I’ll repeat the admonition of Murphy’s Law, “If anything can go wrong – it will,” following it with the Boy Scout motto: “Be prepared.” It’s always advisable if you can cover downside risk with some sort of security. There’s no better example of this principle than in the lending business. The difference between unsecured debt, such as a signature loan, and an obligation secured by mortgage – a document permiting the lender to seize a parcel of property by foreclosure – can mean the difference between wipeout and full recompense. To hew the line even more cautiously, we might further distinguish between mortgage loans secured by owner-occupied single family homes versus those secured by apartment houses. In the event of loan default in the former instance, the owners may avail themselves of various delaying tactics including prolonged bankruptcy action. If the home equity securing the loan is inadequate, the lender may suffer.

But with an apartment loan in many judicial districts, the courts will often award receivership, permitting the lender to commandeer the building and collect the rents during the foreclosure period. It’s this option which can make the difference between loss and gain. It goes without saying, of course, the more clearly you understand the details of an endeavor, the better you’re able to prepare for what might go wrong.

I’ll sum things up. Successful investment can be challenging, but need not be overwhelming. Apply these five fundamentals to each investment opportunity you encounter and you’ll quickly eliminate those with fatal flaws. But keep in mind you’ll not be popular with whoever’s advocating your participation. It’s unhappily true most investments are promoted by interested parties who exaggerate benefits and minimize risks. My advice: Ignore the pitch and rely on your own analysis. And remember always: If it doesn’t make sense to you, it doesn’t make sense.

Al Jacobs, a professional investor for nearly a half-century, issues weekly financial articles in which he shares his financial knowledge and experience. You may view them on http://www.roadwaytoprosperity.com.

al@beachcomber.news

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