In 1949, Benjamin Graham published what has become a foundational work for value investing called “The Intelligent Investor” … it has been hailed by Warren Buffet as one of the most influential books that he has ever read. The fundamental thesis of this book, which is supported by Jason Hartman, is that slow, steady value investing is the path to long-term prosperity. Another key characteristic of Graham’s philosophy is that it requires the ability to resist the temptation of speculating.
In any given year, speculators may out-perform value investors. Typically, speculators ride bubble markets up while proclaiming the virtues of their own brilliance before being humiliated by a market crash that they did not predict. Of course, their humiliation is never so great that it compels them to return all of the management fees they received for funneling people’s investments into a bubble market that was about to crash.
Building on the value philosophy of Ben Graham, we can expand the scope of his teachings to a greater sphere of investments, and optimize them for the current economic environment. The reason why this adjustment is necessary is because a simple mix of stock and bonds is no longer sufficient for investors to build long-term wealth.
The current environment of the United States is one where interest rate yields on bonds are significantly below the rate of inflation, making bonds an ineffective investment vehicle because of their inability to preserve purchasing power. Currently, the yield on a 10-year US government treasury is 1.92%, versus a historical average of 4.67% and a historical median of 3.83%. With inflation running significantly higher than this rate of return, people who invest in bonds will see the purchasing power of their money decline.
In contrast to bonds, we have stocks. However, stocks have had their own problems as of late. Much of this problem has stemmed from the fact that stock returns have shifted from being dividend-based to being appreciation based. As stock values exploded in the 1980’s and 1990’s, the dividend yield on stocks has compressed. This happened as companies realized that investors could be attracted with promises of future growth, instead of dividend payments. This shift has precipitated a dramatic increase in stock prices as people entered the stock market for the express purpose of riding the general increase in prices. For a while, this became a self-fulfilling prophecy as more people bought expecting growth and the growth from people buying created more growth in prices.
Now we are in a situation where the price of stocks has been inflated by multiple decades of fast growth, which has decreased the net yield that investors receive from dividends. Currently, the dividend yield of the S&P 500 index stands at 2.09% with a historical average of 4.39% and a historical median of 4.28%. This places stocks in an advantageous position relative to bonds because of their upside growth potential, but still places investors in a position where their recurring investment cash flow does not keep pace with inflation.
In the current environment, a category that is relevant for investors is income properties. Rental property represents some of the fundamental characteristics that make both stocks and bonds attractive, and provides some additional features that investor’s value. The most important part of income property is the cash flow. When a tenant pays rent, the owner has cash flows available to pay expenses and capture as profits. This is similar to bonds, but the cash generation rate of rental real estate is much higher than bonds in the current environment.
In addition to the cash generation characteristics, income properties have upside growth potential. When the demand for housing increases in a particular market area, it places upward pressure on prices. This can be a boon for investors as it pushes up the price that can be captured if the property is sold. This effect is amplified by leverage from the mortgage that is typically used to purchase a property. This makes income property similar to stocks since the company can borrow money to earn a higher rate of return for the shareholders.
The extra characteristic that many investors value about income property is its resilience to inflation. Increasing consumer prices place upward pressure on both the rents and price of the property. By locking-in your cost of capital with fixed-rate financing, it allows you to capture these inflation-created price increases as net profits.
However, there is an area where income property is challenging, and this is where Ben Graham’s value philosophy can be helpful. By definition, and income property is an un-diversified asset. It is a single property in a single location, and frequently has a single tenant. If anything happens to that property, area, or tenant, it can create havoc for an income property investor.
In the next part of the series, we will discuss the ways that the four pillars of value investing can be used for stock, bond, and income property investors alike to optimize their portfolio for long-term success.
Action Item: Craft a strategy for your investments that is based on fundamentally sound analysis. Use that analytical approach to make disciplined decisions that optimize your portfolio for long-term success. (Top image: 401(k) 2012)
The Jason Hartman Team