March 2018 IssueLong scroll reading

It Was the Best of Times ……

By Edward A. Studzinski

“I have to change to stay the same.”

Willem de Kooning

Horses for Courses

One of the columnists I have a great deal of time for is John Authers, who writes the “Markets Insight” column for the Financial Times of London. On 22 February, his column discussed the publication of this year’s edition of the Global Investment Returns Yearbook produced annually for Credit Suisse by the Elroy Dimson, Paul Marsh, and Mike Staunton. Historically they have looked at stock and bond returns for different markets, going back to 1900. This year for the first time the study included housing and some collectibles, with indices constructed going back to 1900 for wine, stamps, violins, artwork, precious metals, and gems.

Wine, at 3.7% a year came in second to equities. Gold is a non-starter.

Cutting to the chase, equities have outperformed all other asset classes over the long-term. Going back to 1900, equities have produced a real return of 6.5% a year. Wine, at 3.7% a year came in second to equities. Gold is a non-starter, with a real return of 0.7% a year over that period. It has underperformed cash and bonds since 1900. Gold is also much more volatile. It is safe to say you don’t really want to own it except in periods of hyper-inflation or hyper-deflation.

For me, the real shocker was housing. Most of us have grown up with the American dream of owning your own house, taken from the example of parents who bought post-WWII, and then stayed in the same house for fifty or sixty years. Unfortunately, the U.S. has been since 1900 the weakest country studied in terms of the real return from housing, coming in at 0.3% a year. And while there was a decade in the nineties when the U.S. housing market managed equity-like real returns of 6.5% a year, that may have been an aberration.

Now that 0.3% a year for the long-term is still positive for housing, so it at least remains a store of value, right? Last year’s tax act may have put paid to that assumption. Take the example of a couple entering their retirement years, both in their late sixties. For most of the last thirty years, they have lived in a small brownstone in Chicago’s Old Town neighborhood, 2200 square feet in size, with real estate taxes of roughly $18,000 a year. Assuming no mortgage at this point, cash flow requirements are taxes, utilities, and maintenance. If they opt to sell and move to a luxury doorman building, the math becomes more interesting. Assume you purchase a luxury condominium for $3,300,000. Given the Obama tax bill, you can only deduct the interest on the first $1,000,000 of a mortgage. The maintenance fee for the unit is $1500 a month, covering all utilities except electricity. But then you get to real estate taxes – and if the unit has been resold three or four times since the building was built, you have been giving the tax assessor some pretty good market sales numbers for his database. If you assume that the property taxes on that $3,300,000/3200 square foot unit are $44,000 a year, you have $62,000 of annual costs to live there. And now there is a cap on deductibility above $10,000 in state and local taxes. So the cash flow numbers become unstable. And you are probably wiping out the Social Security income for both partners.

It strikes me that this is not a unique set of facts. Rather, it is all too common in cities like Chicago, Boston, New York, San Francisco, etc. If people bought these high-end condominiums and co-ops in their later working years, who is going to buy them from them in their late sixties and early seventies when they are effectively cash-flow stretched? And oh, by the way, over the last three years there has been no price appreciation on that unit, none, zilch, as the identical unit one floor down is on the market for $3,000,000 or $300,000 less.

Rental housing might work if you were changing locations, going from an urban to more rural environment. But staying in the same location the cost of renting comparable housing stock, as one friend in New York City pointed out to me, far exceeds the cost of staying in the same property where you are (and this individual is in another townhouse/brownstone). It just seems to me that we have a whole class of property owners for whom the recent tax reforms mean they most likely cannot afford to stay where they are, BUT, we have also eliminated the incremental buyer demand for those units. Is there a conclusion here? Yes, as in most things financial, timing is everything.

And now a word from Ed’s neighboring state, Iowa.

(Just sayin’, Ed. Love, David)

Water, Water Everywhere

Another real property belief that I think past assumptions about are totally wrong in today’s environment is that there would always be ready liquidity and constant demand for waterfront real estate. The thought that but for the occasional hurricane causing flood surge and beach erosion, coastal oceanfront real estate represents a trophy asset is, at this point, simply incorrect. In many instances the numbers no longer work given the increase in premiums in flood insurance (which are still inadequate for the risks being borne) as well as for the increased premiums for general homeowner’s insurance required. While there are segments of the population for whom coastal land and housing ownership works, albeit more expensively, there are an increasing number of home owners who can neither sell their homes nor afford to remain in them.

And this is not limited to single family homes. An attorney friend of mine went to visit a client in Florida, who lived at a high-rise waterfront condominium in the tony section of Miami. She noticed as she drove into and parked in the parking lot that it had two inches of water covering it. And the flooding ran all the way up to the front door of the building and into it. She inquired of her client what this was all about. He indicated that the flooding was now a constant problem, and there was no way to solve it. Note that this constant flooding presents the issues of mold, rot, and creatures living in the water. And apparently, Miami is built on porous rock, so the rising sea level cannot be stopped in many city areas.

Culture and Conflicts

When I speak about conflicts of interest in the investment world, I have noticed that many people’s eyes glaze over. And in Chicago, where as journalist Mike Royko opined, the unofficial moto is “Ubi est meum?” or “Where’s mine?” this is even more likely to be the case.

Imagine a situation, allegedly not apocryphal. Star Analyst and Star Portfolio Manager are in an investment firm, where they are part of the anointed future next generation leadership and brain trust. Star Analyst comes across an equity investment which he discerns has the potential to be the classic Peter Lynch ten-bagger. He tells his friend Star Portfolio Manager. They decide to hitch their financial fortunes to the idea.

Most investment firms would have a code of ethics that would give priority to the clients of the firm, especially where the scalability of the idea was capitalization constrained. Star analyst and star portfolio manager are told that priority in the investment should be given to the clients. Star Analyst and Star Portfolio Manager both threaten to resign if they are not permitted to buy as much of the investment idea as they wanted, shutting out the clients. The leadership of the firm allegedly caves.

Which brings us to the one advantage that index funds offer, in addition to low costs. And that is, that the index is the index. No one is going to get an advantage in being able to purchase a unique investment idea. Dilbert, who often seems to have hidden cameras in many investment firms today put it best in his February 24/25 Calendar. Frame one has ASOK saying, “I followed your investment advice and lost all of my savings in the stock market.” Frame two has the CEO saying, “Did I mention that past performance is not an indication of future returns?” Frame three has ASOK asking, “Then how does ‘advice’ actually work?” In the same frame, the CEO replies, “It only works for the people that give it.”

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About Edward A. Studzinski

Ed Studzinski has more than 30 years of institutional investment experience. He was a partner at Harris Associates in Chicago, Illinois. Harris is known for its value-oriented, bottom-up investment approach that frames the investment process as owning a piece of the business relative to the business value of the whole, ideally forever. At Harris, Ed was co-manager of the Oakmark Equity & Income Fund (OAKBX). During the nearly twelve years that he was in that role, the fund in 2006 won the Lipper Award in the balanced category for "Best Fund Over Five Years." Additionally, in 2011 the fund won the Lipper Award in the mixed-asset allocation moderate funds category as "Best Fund Over Ten Years. Concurrently Ed was also an equity research analyst, providing many of the ideas that contributed to the fund’s success. He has specialist knowledge in the defense, property-casualty insurance, and real estate industries, having followed and owned companies as diverse as Catellus Development, General Dynamics, Legacy Hotels, L-3, PartnerRe, Progressive Insurance, Renaissance Reinsurance, Rockwell Collins, SAFECO, St. Joe Corporation, Teledyne, and Textron. Before joining Harris Associates, over a period of more than 10 years, Ed was the Chief Investment Officer at the Mercantile National Bank of Indiana, and also served on their Executive and Asset-Liability Committees. Prior to Mercantile, Ed practiced law. A native of Peabody, Massachusetts, he received his A.B. in history (magna cum laude) from Boston College, where he was a Scholar of the College. He has a J.D. from Duke University and an M.B.A. in marketing and finance, as well as a Professional Accounting Program Certificate, from Northwestern University. Ed has earned the Chartered Financial Analyst credential. Ed belongs to the Investment Analyst Societies of Boston, Chicago, and New York City. He is admitted to the Bar in the District of Columbia, Illinois, and North Carolina.