An alternative acquisition checklist
I remember my first lesson in investing. It was about a quarter of a century ago.
I was told that Ford is widely recognised as a successful company that is expected to continue to pay a healthy dividend and achieve ongoing growth.
Then I was asked whether I thought this suggested buying shares in Ford would be a good investment?
I answered “Yes”.
The correct answer was “No”.
Or at least “not necessarily”, as all the information shared with me, while positive, was commonly known and therefore fully priced into the share price.
I then realised that a good investment required a differentiated - and superior view. Therein lay the challenge and I was hooked.
Many years later I would read the work of Howard Marks and realise that this lesson had demonstrated the importance of second-level thinking. As he writes:
“Being right may be a necessary condition for investment success, but it won’t be sufficient. You must be more right than others…which by definition means your thinking has to be different…… Different and better: that’s a pretty good description of second-level thinking.”
It can help to contrast first and second-level thinking. To continue to quote Marks:
First-level thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority). All the first-level thinker needs is an opinion about the future, as in “The outlook for the company is favorable, meaning the stock will go up.”
Second-level thinking is deeper and more complex. It requires an understanding of how your view of the future (or range of possible futures) differs from the consensus view reflected in the market price.
A second-level thinker distinguishes between fundamental risk and investment risk.
Fundamental risk pertains to the outlook for an asset; investment risk is determined by the relationship between the market price and its intrinsic value.
The defining role of price means “there is no such thing as a bad asset, just bad prices” or even “it’s not what you buy, it’s what you pay”.
For real estate investors, there is, of course, recognition that price matters.
Most investment processes will involve an evaluation as to whether the prospective return at the entry price offers sufficiently attractive returns relative to required returns.
But this is often a highly imperfect process. For multiple reasons.
Furthermore, discussion around expected returns too often focuses on, for example, “why are our rental growth expectations high for this market?” rather than “why are our rental growth expectations for this market above consensus?”.
More generally, investment committees tend to focus more on fundamental risk (e.g. leasing risk or competing supply) rather than investment risk (e.g. is the asset cheap relative to intrinsic value? What could delay or prevent alignment between price and value in the future?).
Second-level thinking does not come naturally to everyone. So how can investment processes be adapted to ensure an appropriate focus on the relationship between price and value?
When acquiring a real estate asset, I think that a richer discussion and ultimately better investment decision results from running through this alternative checklist:
Do we have an information advantage in this market?
Do we understand the source of our variance in perception?
Does the investment include an element of complexity we are well positioned to exploit?
Have we secured an opportunity in an uncompetitive playing field?
Is there evidence of heightened risk aversion in the market? Are other investors fearful?
Do other market participants have different investment objectives or motivations (e.g. liquidity needs, different time horizon)
Are we particularly well placed to undertake asset management of this building - to add value in a way others cannot?
Is there a reason for us to assess the balance of risks differently to others?
Through answering these questions, the source of divergence between price and intrinsic value emerges, or becomes explicit.
And a convincing positive response to at least one or two of these questions gives decision makers greater conviction that an asset is going to help deliver relatively strong investment performance.