Investors often view stocks as slips of paper changing hands rather than business interests. A better way, in our view, is to assess each investment decision like you would approach purchasing a house. Major factors to consider when buying a house include but are not limited to: the condition of the house, location, why the current resident is selling, the amount of equity and debt, if any, needed and of course, price. All of these factors draw parallels to the investment process.
House Condition – Most homebuyers will require a thorough inspection before purchasing. No one wants to buy a home only to realize the foundation is crumbling or the roof needs replaced. Investing is similar. Thorough due diligence is crucial when evaluating any potential investment. While it is difficult to uncover every blemish, our process is designed to help reduce our chances of investing in a company with a rotting foundation.
Location – You have likely heard the popular real estate mantra “location, location, location.” Although each buyer has different criteria, considerations such as strength of school system, amount of crime, lot size, proximity to a city and amenities factor into a homebuyers’ decision. Again, there are parallels to investment decisions. A company in a fast-growing industry, run by a great management team and loved by Wall Street may be appealing, but the price most likely reflects all those great things. We may be willing to purchase shares in such a company if the price is right; however, much like a shiny new development being built, the price may be too high, upside limited and a loss on the house possible if things do not go exactly according to plan. Conversely, it may be possible to find great deals in unloved locations and industries where sentiment is so low that everything is underpriced and the likelihood of permanently losing money is reduced.
Why are they selling? – Often a homebuyer will not know the seller and the two will never meet. However, it is fair to ask your real estate agent why the seller is selling. There are several benign reasons for moving: relocating for a new job, downsizing after the kids leave the nest or needing more house for a growing family. Conversely, there are less benign reasons like: neighborhood crime is rising, the school system is struggling to pass levies, the house is in a flood plain or the buyer cannot resist selling at a high price during a hot market. Either way, the seller has the most knowledge of a house and it is important to question why they are parting ways with it. Similarly, when investing, it is hard to know from whom you are buying shares. But you can often get a sense of why they may be selling. Is sentiment overly negative despite no change in fundamentals? Has a company failed to live up to lofty expectations and is course correcting toward fair value? We must do our own digging to understand why. Much like a home seller, company insiders likely have the best understanding of a company’s operations and fundamentals. Insiders can sell for various reasons, but when they buy more stock in their company it generally means one thing: They are betting on the future of the company and believe it is undervalued. The high transaction costs of selling a home make it painful to move. This friction no longer exists when buying and selling stocks due to no commission trades. The ease of trading can allow investors’ emotions to dictate decision making. We let fundamentals lead our investment decisions and typically purchase shares of high-quality companies when they trade at a discount to our estimate of fair value and sell when our analysis suggests they are overvalued.
Debt – Down payment, mortgage rates and income dictate how much house one can “afford.” Being overleveraged is always a risk, as seen during the financial crisis when many individuals bought homes out of their price range with little to no equity. When home prices depreciate, minimal equity can be quickly wiped out. For this same reason, we typically do not like highly leveraged companies because creditors get paid first when things blow up and stockholders can get wiped out. We believe it is important for companies and households to have solid balance sheets so they can comfortably service their debt in times of crisis.
Price – Warren Buffett once said, “Price is what you pay, value is what you get.” After weighing all other factors, cost is ultimately the biggest variable. In the current environment, true bargains are seemingly rare. But assessing the condition of the house, its surroundings, whether improvements can be made to it and how its cost compares to similar houses can help a buyer determine a fair price. Price paid relative to value received is an important factor in determining how investment decisions will likely work out. We require a potential margin of safety before making an investment. In other words, the price we are willing to pay is below our estimate of intrinsic value. When a margin of safety exists, it can reduce the risk of a permanent loss of capital.
Purchasing a house is a major decision for many people. We believe investors would benefit from putting as much time and effort into researching companies as the typical homebuyer puts into finding and acquiring their perfect abode. Factors such as house condition, location, seller motivation, debt and price run parallel across housing and investment decisions. In our view, carefully weighing these and other variables can improve the odds of making good decisions and help minimize the risk of permanently losing capital.
All investing involves risk, including the potential loss of capital. This content is for informational purposes only and is not intended to be personal investment advice or a recommendation of any security or investment strategy. Past performance is not indicative of future results.