I remember reading an article written in the 1990s by an academic finance researcher, one well-received in the academic community, arguing that real estate was the king of all investment vehicles in the post WW II period. How so? Real estate, the author asserted, had not only a higher rate of return than stocks, bonds or cash, but it was also less volatile in price.

The flaw in this argument, which would be obvious to anyone who has ever owned a house, is that the author calculated volatility using only actual transactions. This is the most obvious and straightforward way to proceed. But in the real world, there can be long periods of time–in recession or when interest rates are high–where there are virtually no transactions done. For example:

today’s office market

The current market in the US for big urban office buildings is a striking example of the lack of liquidity phenomenon. Especially in the case of older buildings, they may be half empty, losing tenants, and rents not covering operating expenses + mortgage payments. If a potential buyer were simply to assume the existing mortgage, leaving the owner with nothing, I think there would already be transactions between deep value buyers and current owners. But it looks to me that we’re not yet at the point where owners and their banks are both ready to agree on a formula to share losses.

bank net asset values

same thing

residential real estate

A more straightforward example: my wife and I bought a house in early 1981, when mortgage rates were at 17%. It was three years–and a drop in the fed funds rate from 19% to 5%–before there was another transaction in our neighborhood. This wasn’t because no one wanted to sell. It was because any offers taken, at maybe 60% of what we’d paid, would have made the sellers worse off.

junk bonds

…municipal bonds, too. …and to a lesser extent off-the-run government bonds.

These are all what are called “original issue” securities, meaning they trade a lot around the time of the public offering and then trading volume dries up to the point where they trade “by appointment only.”

I don’t know enough about munis to comment.

During the late 1980s junk bond blowup, investors found that their junk bond funds were being priced, by industry custom, at “last trade,” which might have been many months in the past. So any redemptions created substantial downward pressure on fund NAVs.

In 1998, Long Term Capital Management, whose board was led by Nobel Prize-winning academics, imploded, in large part because of its huge holding in illiquid “off the run” Treasuries (meaning Treasury issues not used in the creation of financial derivatives). It needed a gigantic, government-orchestrated bailout–and two years–to help it unwind this illiquid position.

more tomorrow

In the fantasy world of academic finance, in which (among other curious assumptions) all knowable information is posited to already be factored into the current price of every stock, risk–the chance of making or losing money–boils down to volatility.

The main virtue of this assumption is its simplicity. …no need to analyze company financial disclosures, study competitors, read government economic research, listen to trade associations, visit the stores, use the products, sit at a trading desk or put money at risk by actually buying or selling stocks.

There is some intuitive sense to the idea. Take a hypothetical stock that trades all the time at $10 a share. Compare that with one that trades at one of $10, $9, or $11, and where trading in the aggregate averages out at $10. The second is riskier in the sense that your trade might end up being a sale at $9 rather than at the for-sure $10 you’d get in the first stock.

Suppose, though, that the second stock is one that is guaranteed to go up by $.10 each trading day. It’s certainly more volatile than the first but it’s hard to say it’s an inferior investment to the dead-in-the-water one.

more tomorrow

One of my early mentors, a dyed-in-the-wool value investor, said that any experienced investor should have an annual performance goal. He thought a reasonable number would be +20%. By “experienced” he meant someone who could: read and interpret company financial statements, project future earnings and understand both the economics of firm vs.firm competition and general macroeconomics.

This is prettty simplistic stuff. On the other hand, simple models often work significanly better than complex ones.

The world has changed a lot since then, when we were in the early stages of a decades-long decline in interest rates, and had a domestic economy that was growing in real terms at 2%+ (vs. maybe 0.5% now). So maybe +15% is a more reasonable aspiration today.

Why write about this now?

It’s because we’re in early March and are already up by around +7% ytd for the S&P 500 and NASDAQ. The laggard is the Russell 2000, an index of mid-cap, predominantly domestic earning, firms, which is around +2%. So if we take my rule of thumb as a reasonable guide, a lot of work for the year has already been done.

I don’t see any reason to go into a defensive shell–of course, though, I almost never do–but it’s probably time to do a sanity check on holdings. In particular, in a flattish market valuation will likely be at least as important as concept. And rather than a rising tide lifting all boats, the winners in inter-firm competition will likely significantly outpace the rivals they are trouncing.

TGT reported surprisingly strong earnings yesterday. To me (I’ve held TGT shares for a long time and have been buying more over the past few months), this signals two things:

–the company is finally through the whopper of an inventory mistake it made during the pandemic–that is, its big bet that demand for stay-at-home consumer electronics and computers… would stay strong for much longer than it did. I don’t know the details, but I imagine this was a combination of too much unit volume and overpaying (like paying high freight charges for faster dellivery and waiving the right to return unsold stuff). In any event, inventory is, at last, back to normal (or close enough that it’s no longer an investment issue).

–more important, I think, is what it may signal for the economy as a whole. As the business cycle ages and the economy begins to flatten out or contract, consumers respond by changing the venues where they do most of their shopping. Generally speaking, high-end consumers shift down to TGT. TGT customers shift down to Walmart (WMT), WMT customers to the dollar stores, and dollar store customers to less expensive retailers who fly below Wall Sreet’s radar.

When the economy begins to recover, which is where I think we are now, consumers reverse course and return to their good-times shopping venues. My guess is that this is what TGT’s January 2024 results are signalling.

Typically, this is a signal to dump the dollar stores/WMT and buy TGT and the higher end. I held onto my TGT and moved more into semiconducters instead. So I’ve had no lower end to shift out of. Had I done the conventional thing as recession loomed, however, the shift up would clearly be the move to make, I think.

One other thing. I’ve just bought a small WMT position. Yes, this runs counter to what I’ve written above. Mostly, it’s the Vizio purchase that interests me. I also just bought a Canon lens from WMT online–it was about $200 cheaper than the next cheapest alternative. …not much to go on, but it suggests to me that the WMT management may no longer be as sleepy as I’ve thought. If so, earnings growth may not soften as much as the consensus expects (or at least should expect).

I’ve just updated my Keeping Score page for February.