Price Matters
Buying undervalued property reduces risk.
These conservative acquisitions produce a margin of safety alongside upside opportunities for investors.
Yet in thinking through risk, I often find it helpful to study strategies that prioritize risk management as a function of the asset class. It’s where the most salient takeaways are found.
Distressed debt investors have a particular emphasis on risk management, as they acquire the debt of troubled borrowers at a discount and pursue various strategies to increase its value.
One such investor, Howard Marks, recently released a set of videos analyzing risk from a variety of different perspectives.
One of the segments aligns particularly well with my investment philosophy. In it, Marks considers how the combination of pricing and asset quality affect the risk profile of an investment.
Here’s a brief 3-minute video from Marks explaining his position:
A few key takeaways from this talk:
Risk is not a function of asset quality
A high-quality asset can be priced so high that it’s risky
A low-quality asset can be cheap enough to be safe
In turn, the price paid for assets is critical. From this it follows:
It’s not what you buy, it’s what you pay
Investment success doesn’t come from buying good things, but from buying things well
A Tale of Two Fund Managers
To put this into concrete terms, let’s consider two fund managers. The first manager, let’s call him Trophy Trevor, only wants the highest quality assets. He views them as a status symbol and loves bringing them up at dinner parties.
However, since many other investors are looking for high-quality assets, Trevor’s fund pays top dollar for the trophies he collects.
Suppose Trevor’s most recent acquisition was a beautiful golf course overlooking the water. There were many investors vying for the asset, but Trevor acted quickly and secured the property at 95% of asking price.
Trevor’s already looking forward to hosting the next investor event at the property and regaling his partners with highlights from the latest golf tour.
He feels he’s done well by acquiring a high-quality asset for the fund.
The other fund manager, let’s call him Value Vaughn, remains intent on buying undervalued assets.
He’s not concerned about the quality of the property in and of itself. Instead, he’s focused on the quality of the property with respect to its price.
He specializes in overlooked property and acquires assets significantly below market value.
Vaughn’s latest acquisition was off-market land purchased directly from the seller. Since there was little competition, he bought it at 60 cents on the dollar.
After completing a subdivision to increase the land’s value, his fund’s basis is further reduced to 40 cents on the dollar.
Which fund has more risk exposure?
Trophy Trevor’s at 95% of market value
Value Vaughn’s at 40% of market value
If the market contracts by 10%, Trevor’s fund will be underwater, while Vaughn’s investors enjoy a significant margin of safety.
To achieve results, Trevor’s fund is largely betting on cap rate compression, whereas Vaughn’s fund focuses on fundamental value.
Price Matters
It’s clear that price matters when making investments. Risk is not a function of asset quality alone.
So, evaluate the convergence of price and quality.
We’ve found this strategy produces the best results for investors.