Preparing for Extra Innings

Preparing for Extra Innings

Aug 1, 2019

Financial news consumers are familiar with sports analogies. There are regular mentions of full court presses, goal line situations, holes-in-one, sprints, marathons and throwing in the towel.  Many come from baseball.  Home runs, strikeouts, swinging for the fences and keeping an eye on the ball are just a few. 

For those not attuned to America’s pastime, extra innings are necessary to break a tie after the standard nine innings have been played.  Anyone following today’s commercial real estate literature has read about extra innings used to describe the extended U.S. economic expansion, the mature real estate cycle and elevated property prices.  Pundits have been announcing the start of extra innings since 2015, when a “typical” seven year real estate cycle would have reached its maturity.

So what if we are in extra innings? How can an investor prepare for uncertainty?  Since 2016, a Gratus Private Markets (GPM) objective has been capital preservation.  We seek investments that are well positioned to preserve capital in both the current environment and any potential future economic slowdowns.  Below are topics to consider:

  • The Trouble with Forecasting

  • Sitting on the Sidelines

  • Preparing for the Last War

  • A Deep Bullpen: Preparing for Uncertainty

The Trouble with Forecasting

Economic forecasters have a horrible track record.  Forecasters failed to predict the Great Recession that began in December 2007.   Out of 153 recessions in 63 countries from 1992 to 2014, only five were predicted by a consensus of private-sector economists in April of the preceding year.

A forecaster’s job is extremely difficult due to their reliance on incomplete, lagged and unpredictable information.  Also, forecasters are poorly incentivized to stray from the herd.  They are safer in the crowd.  They are more likely to remain with the herd and miss a recession than to predict one that doesn’t occur.  Alternatively, a forecaster could constantly predict a recession [1].

In hindsight, one can always find a correct forecaster, but it doesn’t mean you should listen to them the next time.

Why Do Investors Bother with Forecasts?

Not only are thoughtful experts bad at forecasting, but there are plenty of low-quality opinions in headlines and soundbites. Michael Mauboussin observed that “the talking heads on television satisfy a human need for an expert, without providing the value of an expert.”   Like a patient receiving a placebo, an investor feels better despite receiving no substance. Or worse, the investor receives harmful advice.

Commentators will often try to distill the vast landscape of economic indicators down to one metric: often the stock market.  Should a market correction signal a recession and thus serve as a catalyst to act? Possibly the greatest economist of the 20th century, Paul Samuelson, quipped, “the stock market has forecast nine of the last five recessions.”

Our conclusion is to be wary of forecasts and don’t let fear steer you away from your personal investment plan.   

Sitting on the Sidelines

We don’t believe that market timing is an effective investment strategy.  Attempting to time the market and potentially avoid loss by allocating to cash, aka “sitting on the sidelines” (another sports analogy), would miss the best performing days of the market.  Better to have a robust portfolio and remain engaged in your personal investment strategy. 

Let’s imagine an investor decided to keep their investments in cash.  Perhaps, for example, during an event such as 2008 or the December 2018 market drop. 

J.P. Morgan Asset Management’s 2019 Retirement Guide showed that over the twenty years from 1999 through 2018 that missing the top 10 best performing days of the S&P index would cut overall returns in half.  If an investor missed the top 20 days over this time period, the return would become negative. 

The lesson here is not to time the market, but to stay engaged and take the good with the bad.  By staying invested in the market, an investor ensures that they will capture the best days.  Taking it a step further, an investor should prepare for risks by having a plan.  Investors should have a purposeful investment allocation that meets their specific needs. This investment allocation can contain such categories as stocks, bonds, alternatives and private investments.

Preparing for the Last War

Generally speaking, many Gratus Private Market investments involve real estate.  We continually evaluate real estate for its merits and we believe that it remains attractive.  Over the last decade, real estate has received extra scrutiny because of the U.S. housing sector’s role in the previous recession.  The extra scrutiny will likely create an environment of over-preparedness as market participants “prepare for the last war.” This means believing in and using a strategy that was or would have been successful in the past but may not be a relevant tactic in the present.  

Regulators, lenders, investors and operators are more disciplined and less likely to repeat the errors of the past.  The over-preparedness is one reason to expect a “soft landing” in real estate and an explanation for the prolonged cycle. 

Another opinion is that because the real estate sector was hit so hard during the last recession and because the sector came from such a low base, much of the current cycle was getting back to par (another sports analogy).

A Deep Bullpen: Preparing for Uncertainty

A successful baseball team will need a reserve of skillful pitchers for extra innings.  GPM investments strive to be like a team with a deep reserve of talented pitching. 

Many GPM investments are positioned well for the current environment, for an extended real estate cycle and a potential economic slowdown.  The following themes help illustrate the resilience we seek in private investments.

1. Capital Position

An “advantaged” position within the capital stack is a higher allocation towards debt. First losses will be felt by the equity investors. For example, real estate lending investments are firmly within the debt portion of the capital stack.

GPM investments also invest in the middle of the capital stack.  For example, there are preferred equity positions that trade away some up-side potential for the benefit of receiving payment before the common equity position.  There are co-investments that receive a portion of a manager’s asset management fee. There are single-tenant “net lease” investments that provide moderate returns but behave like a corporate bond with high-credit tenants paying rent instead of interest payments. 

Collectively, these investments, from basic lending to negotiated arrangements, work to increase the likelihood that our investments perform well during a down-turn. 

2. Recession-Responsive Strategies: Resilience

Many property types are recession resilient.  For example, workforce housing (owned or rented housing that is affordable to prevailing incomes and within reasonable proximity to the workplace) provides a safe home with minimal amenities. Demand for these properties do not require a booming economy and demand may increase during a recession.  Medical office and healthcare facilities are required regardless of the economy’s health.  Issuing short-term loans (18-36 months) provide the option to re-evaluate in a changing environment.  Should an economic slowdown reduce returns, capital can be withdrawn, halting new loan origination. Lastly, over the last three years, GPM investments have largely avoided development projects.

These types of investments perform well during economic booms.  By avoiding development, new supply and high-end product, we seek to reduce economic slowdown risks.

3. Real Assets

Real assets (property, medical equipment, infrastructure, etc.) use the term “real” to describe their tangible nature or utility.  The term “value investing” originated from buying underpriced assets, mostly stocks with low price-to-book-value.  Value investing today is becoming more difficult due to less meaningful book values and the importance of intangible assets to digital era companies.

GPM investments tap into the core of value investing: tangible property and an asset’s utility. Real Assets also provide inflation protection, a store of value and tax advantages [2].

4. Value: Realized Returns aka the Bird in the Hand

GPM investments seek income.  These returns are “realized” as opposed to the “unrealized returns” provided by appreciation in unsold buildings.  Realized income has already been achieved and cannot be erased by future economic slowdowns.

5. Diversification

There is safety in numbers.  Though Gratus seeks the most attractive geographies and property types, diversification will help reduce the effects of any single investment that underperforms. 

Final Thoughts

Mark Twain is often quoted as saying that, “History doesn’t repeat itself, but it rhymes.”  Recessions are always looming.  Investors should not let grim forecasters deter their personal investment plan.  Gratus Private Market investments seek to provide an all-weather solution by positioning for both good and bad economic cycles. 

Authored by:

 

   

Patrick Nolan, MBA, CAIA®

Portfolio Manager – Private Markets

Investment Strategy

 

Disclosures:

The above article is intended to provide generalized financial information; it does not give personalized tax, investment, legal or other professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other matters that affect you our your business.

About Gratus Capital, LLC

Gratus Capital is a consultative wealth manager focused on serving successful individuals, families, foundations, endowments, and other institutions nationwide. We offer comprehensive financial planning and active portfolio management. Clients benefit from having a dedicated team focused on providing invaluable counsel, recommending intelligent, custom solutions, and upholding fiduciary standards. Contact us today to learn how we can help you reach your financial goals.