Preston Pysh  4:58  

I think that that’s where maybe a lot of people misunderstand this quote. People think that he could take that million dollars and invest in the stock market and get a 60% return. I don’t think that that’s what he’s saying here at all. I think what he’s saying is, I can run a business well enough to get a 60% return on $1 million that I would be controlling, and then I would be managing. I think that’s really important for people to understand because everyone automatically thinks that he’s just a stock investor. But I think maybe Buffett’s greatest strength is that he’s a business owner and thinks like a business owner first. And then he thinks, okay, here’s some retained earnings that I made from my operational business. And I don’t have necessarily something that I find would be giving me a high return. So let me invest that in the market. And then let me see what else I can do to add to my operational business. I think that’s really his mindset. 

So, awesome question. I really enjoyed that question a lot. Alright, Stig, so who’s up next?

Stig Brodersen  5:57  

That is Ross and he has a question about catalysts.

Ross  6:00  

Hey Preston and Stig. This is Ross from London. First off, I want to say I’m a big fan of your podcasts. Keep up the great work educating listeners about the merits of value investing. Being a value investor for years myself, and it’s great that more and more people are interested in it. So my question relates to catalysts. In particular, I’d be interested to hear your view on whether you think catalysts are an important part of value investing. There are certain value investors such as Mohnish Pabrai, who think that value creates its own catalyst. Other value investors believe that in order to crystallize the value within the opportunity you see, you might need something like a change of management or restructuring of the company, etc., in order for the market to recognize the value that you see, and for the shares to correspondingly move. Really interested to hear your views. Keep up the great work. Thanks.

Preston Pysh  7:07  

All right, Ross. Good question. This is something that I think plays into a couple different things. The first one is George Soros’ book comes to mind whenever you first mentioned this, “The Alchemy of Finance”. Where you get into this idea that sometimes because a business is doing well, it can even perform better because they have more access to more capital, maybe a business that would represent this idea would be a Tesla. It also works in the opposite direction when a company is getting punished, it’s going to get punished more. We’re currently seeing that happening with Deutsche Bank, where Deutsche Bank is doing poorly, everyone has concerns about them being solvent, and now their access to capital from bond buyers to everybody else, the yields are going up because no one wants to supply the capital and potentially get bailed into the common stock if they would go under. And so you see that kind of playing out and it compounds and becomes worse just because of the psychological piece to these. 

So, I would tell you this is a really difficult question to answer. Well, simply because it’s really situational-dependent. But, I do agree with Soros’ thesis in his book there. And just so everyone knows we have an executive summary for that book if you guys are interested in reading it. In fact, we’ll make a link in our show notes to it if you guys are interested in checking it out. As far as going beyond that, when you’re talking about a deep value pick, if you go to Toby Carlisle’s book which in my opinion is probably one of the best books ever written on value investing, and I know I’m biased because I’m friends with Toby, but I’m being serious. I’ve read a lot of books on value investing, and I think Toby’s is phenomenal. And in his book, what he really kind of demonstrates is that catalysts are no catalyst. When you get into this deep value selection, and you’re doing it across the basket of stocks, call it 20 different stocks that you use that same criteria for over time and has proven that it beats the market. And so in that scenario, you’re not really waiting for any type of catalysts to change in management or anything like that. You’re not waiting for any of it, it’s completely passive. Based on that, I guess you’re not really waiting for that catalyst of a management change to occur in order to make the selection and still be able to beat the market. So I would tell you, I think that that definitely plays into it. But I think that if you’re exercising an approach where you have a basket of picks that you’re kind of using the same methodology for in order to make the selection, I guess you could maybe say that you don’t necessarily have to pinpoint when that catalyst actually occurs. So, I’m curious to hear what Stig has to say on this one.

Stig Brodersen  9:41  

I think the discussion about catalysts is so interesting because there’s really no right answer to this. And even [Benjamin] Graham was asked about it, and he wasn’t really sure about how to address it. He just said that he could have served that if we only look at value in itself. Intrinsic value as a catalyst, he would say, he observed that 18 months was a somewhat good estimate in terms of when that reversion to the intrinsic value would happen. But he also said it was extremely volatile. And you couldn’t guarantee that it would happen for a long, long time. So, I think it’s hard. And even the smartest people have been talking about this. And I think one of the most common misperceptions is that we often talk about positive catalysts. So we talk about a great earnings report, we talked about a merger or activist investor. We haven’t really been talking too much about negative catalysts. And I think that there might be something there for a lot of value investors. Because when something comes out there, and it’s really, really ugly. Something that just recently happened and we are recording this October 3 is for instance the entire situation with Wells Fargo. And I’m not the one to say that it’s not as bad as it sounds, or whatever it is, but whenever you hear a story like that, you just see the stock being crushed and what you also see is a recovery, some time later. And hey, time will tell whether or not that’s right. But you hear Wells Fargo, you hear Deutsche Bank. Basically what I’m trying to say here is that you often see this as a great buying opportunity if you can filter out the noise. And again, I’m not saying that you should just pour in all your money into bank stocks right now. This is definitely not what I’m saying. But it’s just saying that if you can really look into the core of the problem. Negative catalysts, very, very often is a very, very interesting buying opportunity. So really, to answer your question. I think it’s important, but I would definitely agree with Preston in terms of if you’re not able to look at that. And if you are looking at value, which is the most common catalyst to think of, you need to have a basket of goods. Otherwise you will probably just end up being very, very stressed about your approach.

Yeah, and I think that last point’s really important because if you’re doing this for an individual company, and let’s say you’re not distributing your risk across the basket, and you’re really relying on some single event to occur in order to basically change the trend or change the direction like a change in management or whatever it might be. For like Deutsche Bank, maybe the Department of Justice is now going to take their original $15 billion fine, and they’re going to change it to $5 billion, or whatever it might be. If you’re waiting for that event to occur. You’re really getting into this idea of what I’ve heard people call as binary investing. Where if one event happens, then you’re going to win, and if the other event doesn’t happen then you’re going to lose. And I think when you put yourself in that situation, you actually create such a stressful situation for yourself over the long haul because you’re dependent on something that’s going to occur, and you have no idea or you have no control over how that’s actually going to happen. And that’s where I think really doesn’t become fun for people when you’re not enjoying the process when you’re investing like that. So just some things to think about. 

Preston Pysh  13:05  

Alright, so who’s up next, Stig?

Stig Brodersen  13:07  

That is Jeff and his question about real estate. 

Preston Pysh  13:11  

Oh boy. Okay, so Jeff and he’s got a question about real estate. And here it comes. 

Jeff  13:19  

Hey Preston and Stig. This is Jeff from Central PA, being there is such a large aspect of most people’s lives. I’m really curious what your thoughts are on home ownership as an investment. Any other ideas you have about REITs, real estate investment trusts, or just investment properties in general, when considering sort of a wealth accumulation, short or long term investing strategies be really appreciated as well? Thank you for everything you guys do and all the great information you share. 

Preston Pysh  13:52  

Jeff, so I like your question a lot because I think everybody out there wants to talk about this subject but I have a feeling that I’m not going to make any friends with my response. So this is my opinion on real estate. We have these interest rates, and these interest rates have been going down for 35 years. And when that happens, the value of everything from stock prices to real estate to whatever, go up. And now we’re at a point where interest rates, where’s the 10 year Treasury, Stig, do you know like 1.7%?

Stig Brodersen  14:33  

Yeah, something like that.

Preston Pysh  14:34  

Something like that. That’s really low. And it could go lower. And how much lower it could go. It might not go lower. It might start going up. I don’t know. But I do know this. There is an enormous amount of pressure for central banks to try to continue to push those interest rates as low as they can possibly go. And as long as that happens, I think you’re going to continue to see real estate hold its current price, especially for single homes for just like the individual person who has a house. I think that you’re going to continue to see these prices hold. The price of the house is more dependent on long term interest rates, like the 30-year Treasury. I think you’re going to see the Fed, and central banks around the world continue to try to push down long term interest rates, which is going to be favorable for people that own real estate, in the sense that you’re going to basically continue to have the price of your house protected. Where this gets really concerning for me, is when that trend reverses itself. And you see interest rates start to go up. I think that there is going to be a very difficult time for people owning a house if that happens. 

Now, with all of that said, and the fact that I painted that there could be this bad scenario that would play on. I have no idea if that’s going to happen this year, or five years from now. I really have no idea what to tell you. And I think if somebody does tell you that they know, run away from that person as fast as you can, because they’re probably full of it. And so let’s go down this path a little bit. Let’s say that we get in a position where interest rates start coming up. I think the Fed is in such a tricky situation, that if they allow that to happen, they’re going to see some major issues in the real estate market. And so I think they’re going to fight that as hard and as aggressive as they possibly can. And I have no idea what that’s going to look like. But I will tell you this, I think it’s concerning. Now, the person who really needs to be concerned when we talk about this scenario that could potentially play out is the person who owns the equity of the house. 

So let’s say that you own a house. And let’s say that you own 20% equity of the house and the bank owns all the rest. The bank, in that scenario would be the one that would really take a major hit on the 80% of the equity that they would be holding. You as only a 20% equity holder probably won’t get hit nearly as bad. And the reason why is because you borrow at a certain rate. Now we’re getting into whether you have a fixed loan, you have a variable interest rate loan, but I’m assuming that you have a fixed rate loan. If you have a fixed rate loan, and you were able to lock in the interest rate right now and interest rates go up. The bank gets crushed in that scenario, especially if you own a small portion of the equity. So you’ve got to figure out where you stand in all of this. Do I have a majority of the equity? Because if you do, the value of your house might go down if interest rates go up, and that would be bad for you because you might want to take out loans against that or whatever. I don’t know what you want to do, but I think that that’s a concern. 

So those are my opinions. And I know that that really doesn’t help people because there’s no timeline to whenever any of this could potentially happen. But I will tell you this. Rates are getting low, and I don’t know how much lower they can go before this trend, this long 35 year trend can reverse itself. 

The last thing I want to talk about is the REITs. So if you take real estate property and you have a commercial, let’s say you have a big commercial apartment complex or something like that. When you buy this as an individual investor, oftentimes, you can get some decent capitalization rates for this like, I don’t know, a 10% rate, which would give you a 10% yield based off the cash flows and the price that you get for. So the cap rate is what you’re paying attention to as an individual real estate investor, which the cap rates are decent. I don’t know if they’re fantastic or what but let’s just call them decent. When you take that real estate property, and you mince it up into a bunch of tiny little pieces, and then you sell all those little pieces on the open market. Now what you’ve done is you’ve taken a property, let’s call the value of the property $10 million if you were buying it as an individual person. When you have a $10 million property and you’re selling that to another person or another company, the price is not as competitive in order to be bid up. So that’s why you’re able to get a higher yield on it. But when you take a bunch of properties, and you mince them up into microscopic pieces, and you sell those on the open market, now you got everyone in their kid sister that has the availability to bid up the price of these shares of the real estate. 

So, I think you’re already paying a very high price with very little yield when you’re talking about REITs. And my concern, going back to what I originally said about the individual houses is true for commercial real estate as well. So If you see interest rates start to reverse themselves and go up. I think that if you own REITs, I think it could be a really bad situation. And here’s the reasons why. Number one, the value of the property itself goes down. Number two, real estate has an enormous CapEx, capital expenditures. In an environment where interest rates go up and you have inflation, your CapEx eats you alive. And that’s why I am a very big bear on REITs. I do not like REITs at all right now specifically because of where interest rates are at and which the direction that I think they might go in the next 30 years. So that’s why I’m not a real big fan of REITs. But I would love for people that are listening to this, either hit us up on the forum, hit us up on Twitter or whatever, tell me why I’m wrong. Tell me why you don’t like my analysis because I would love to hear it. I’d love to maybe talk about that on a subsequent show. And throw that out there for peoople to let the community hear some different thoughts on this. So I know that was really long. I’m sorry, Stig. He’s always so patient with me. Thank you, Stig. Go ahead, buddy.

Stig Brodersen  21:06  

Yeah, so I’m not too crazy about real estate as an investment for a lot of reasons. One of them is kind of like a big picture. So let me start with the big picture in terms of looking at the capital appreciation, which is something people think about a lot. So now I’m really talking about the home owner. And if you look at it in the long run, I think we even talk to Dr. McCormick about this. He said, we’re something around inflation. If you look away from inflation, there was almost like no return at all. This was also something [Robert] Shiller actually proved some time ago. So another thing and this is not an investment thing. This is really interesting. I read a book about this, about the concept on money and happiness related to real estate. It actually shows that if you buy real estate up to a certain level, you actually don’t gain anything in your happiness in terms of spending more money on that home. I just think that was a really interesting observation. One of the reasons for this is quite a few, but just want to highlight one is that whenever you buy something that is more expensive, and think that it makes you happier, you would move into a more expensive neighborhood. And the extra happiness you get from the extra features you have in that house are completely deluded. When you look at your neighbors, and they have the same things. So it actually doesn’t make you any happier in the end. So I kind of think that was included from factors like if it’s safe to live in the neighborhood or like nice neighbors and some of these things. Actually the quality if you want to call them like four or five bedrooms, whatever it is, really makes no difference. Another thing in terms of you’re paying money to yourself, especially considering that you might not have any capital appreciation. Is that still a good business? It’s actually not. If you really crunched the numbers, it’s actually not a good business to pitch yourself which is, as Preston mentioned, typically the bank anyway. Also because you need to factor in the amount of time you usually need to spend having your own home compared to renting. No more paperwork. If you have a house, there is also like the garden or you have to pay the gardener, whatever it is. So actually, across the board, there was no economic reason to do that. There might be a lot of other emotional reasons to that, but no. So sorry for this unpopular answer. 

Another thing I would like to talk about in terms of REITs. So that was another thing I would also like to address. In general, people would look at REITs for a few different reasons. One of them is that they are somewhat uncorrelated. At least that is the reputation that they have. I don’t necessarily fully agree with that, but I can definitely see why in terms of it’s not really a stock, it’s not really a bond because it’s real estate. But Preston was also talking about cap rates before. Then it is so that if the assets in general are overvalued. If stocks are overvalued. If bonds are overvalued. It doesn’t take long for investors to realize if they have an asset class like REITs, the money will flow into that which will basically just up on this the cap rates. So that’s another thing to consider. Unfortunately, there’s like no hidden asset class that just gives you a tremendous, better return compared to risk right now. 

Another thing is also that in general, they will pay out a lot in dividends. Not necessarily in absolute terms, but in relative terms to whatever they’re making. So if you’re an income investor, it might be a good idea in general to look into REITs, but it’s not always the best vehicle in terms of maximizing returns. I mean, that was more of a general observation, not so much like specifically what is good in the current environment precedence you have seen

Preston Pysh  24:42  

Whenever you do see the high payout ratio on these REITs where they they’re paying a fat dividend. Sometimes you got to really dig into whether it’s a sustainable dividend because I see a lot of people that will throw a REIT pick at me and I kind of dig into the numbers and I look at the history. You can really see that they’re not going to be able to sustain the market price. You’re getting paid a 4%, dividend, that’s not sustainable. So you paid $20 for the REIT, and by the time you get out of it, you sell it for $16. And everything that you lost in the market price of it was what you gained on the dividend. So it was a completely flat purchase. So I would warn people on that as well. Go ahead, Stig.

Stig Brodersen  25:21  

Yeah, definitely. And another thing to think about is that REITs are regulated differently at common stock. So, Preston will talk about the sustainable dividend payment. A lot of these REITs are regular in terms of the need to pay a given amount of the cash in dividend. So that’s another thing to think about. It’s not as flexible as a common stock. They can just say, well, we’re facing some headwind here. We’ll just stop doing that because we really need to accumulate cash.

Preston Pysh  25:45  

I really like apartment buildings if you’re going to buy them outright and own it completely for yourself, and really kind of own all the equity yourself, especially if it’s more of a lower income apartment complex. Simply because I think that moving forward if interest rates do go up. And for me, that’s the worst case scenario. When you’re assessing the risk of doing this, that’s the risk as far as I’m concerned. So if you’d buy this and you’d obviously be leveraged, you could lock in a pretty decent interest rate right now. If it’s lower income, I think that your ability to maintain the occupancy rate and keep people renting the actual apartments and not have a low vacancy, I think that that would probably work out well for you. And especially because I think when you look at some of the cap rates on these, they’re fairly high compared to where interest rates are. I want to say some of them, “this is completely dependent on the area where you live”, but I mean, some cap rates might be 7% to 12% depending on where you live. So I think there’s decent money to be made there, especially if the apartment that’s being rented is for a lower income. You run into more issues and more troubles if you will, with as far as the maintenance and stuff, but I think that might not be a bad purchase even though I’m very negative on a lot of the other things that I had mentioned earlier. 

Stig Brodersen  27:00  

Perfect. 

Preston Pysh  27:01  

All right Stig. So what’s our next question?

Stig Brodersen  27:03  

It’s a question from Konak Chen, and it’s about bonds in Brazil. So I don’t think we’ve ever done that before, Preston.

Preston Pysh  27:11  

I’m sure my guidance will be just awesome.

Konak Chen  27:15  

Hi Preston and Stig, first I would like to thank you for the wonderful podcast and the resources online. My question has to do with inflation between countries. And for this, I’ll tell you about my own example. So right now, I can buy a Treasury Bill in Brazil for about 13% yield per year. And let’s say, I buy this today. And next year, I decided to liquidate it and transfer it to the US. I’ll say with fees and after the exchange rate, I’ll have about 10%. And since the inflation rate in the United States is not as large as in Brazil, and also assuming that I spend everything in the US, will I have effectively beat inflation? Thank you.

Preston Pysh  28:05  

All right. So Stig is the expert for everything in Brazil.

Stig Brodersen  28:11  

Oh, thank you for saying that. But I really like this question. And I like this because it’s about foreign bonds. And we see these high yields out there for foreign bonds. And if we’re thinking, “okay, the 10 year Treasury in the US, that’s 1.7%, why don’t I just go ahead and get 13%, Brazil?”. What’s kind of risk to it is actually I have when I do that. So first of all, we need to define a few things. If we’re talking about a coupon rate of 13%, that’s one thing. So basically, that means that if you buy a bond of say, unit of 100, and it’s 13%, you will get 13% or whatever that unit you would get back. 

Now, so this is my next question. Whenever you see that 13% is that the yield to maturity? Or is it just the coupon rate? Before, I used the example of 100. Are you paying like 95 for that? Are you paying 105? What are you really paying for that bond to get that 13%? But let’s just assume that you have a yield of maturity of 13%, so is that a good investment? Usually, when you buy something in another country, you would have to buy in that currency and the other American instruments. But in the event that you will have to buy this Brazilian Real, you also need to factor in the inflation as you also talked about. Now, the inflation right now in Brazil is 9%. So if you’re getting 13% in Brazilian Real, you can expect that to be diluted by 9%. So it’s not that interesting anymore, because now you’re going to 4%. Before we had 13% and 9% inflation, you have 4%. 

Then you also mentioned a few other things. You need to convert the currencies, that’s also gonna be expensive. There’s also commissions, so that’s another expense. And you still incur a lot of risk at the same time. Because we don’t know I’m having a year, like, right now, the inflation is 9%, then you might sell in a year and get those 4%, deducting the fees or whatever it is. You might still think it’s a good investment. That’s true. But you don’t know what will happen to the interest rate in Brazil. I mean, I don’t know what’s going to happen to the interest rate in the US. And I can assure you, I have no clue about the interest rate in Brazil. So depending on what happens to that, the bond might not be worth that much if you want to sell it in a year or two, because the interest rate changed. So, I don’t know if I’m the Brazilian bond expert. I guess, I’m really trying to say I’m not the Brazilian bond expert. I’m just saying like, there are quite a few things you need to be completely sure of before you do that. One thing that you can be sure of though is that it will be expensive to go in and out that market. Whether or not you will get a good return in that market, I don’t know. But in terms of fees, commissions, you do incur a lot of risk too and that’s another thing. And now, Preston is smirking because he’s the deputy in the Brazilian bonds department here on The Investor’s Podcast

Preston Pysh  30:59  

As your deputy, sir, you did a fine job, let me tell you. I don’t really have anything else to add. I think you hit all the high points that you have in inflation in the country that you’re actually holding the security. I think that your comment on the yield to maturity versus the coupon was a very important highlight that I think a lot of people don’t understand. So yeah, you knocked it out of the ballpark, Stig. Spoken like a true deputy.

I think that’s all we have. Right, Stig?

Stig Brodersen  31:28  

Yeah. 

Preston Pysh  31:29  

All right. 

Stig Brodersen  31:29  

Awesome questions, guys.

Preston Pysh  31:31  

Yeah. Thank you guys so much for sending your questions in. 

Alright, so thank you guys so much. If you guys want to get your question played on the air, go to asktheinvestors.com. For everybody that sent their question in, they’ll get a free signed copy of our book, “The Warren Buffett Accounting Book”. And you also get Stig’s free course, his video course that he made for “The Intelligent Investor”. Very difficult book to read, and Stig completely made it simple. It’s a paid course that we have on our website. But for everybody that got their question played today, they’re going to get that course completely for free. He goes chapter by chapter teaching everything in video format.

Stig Brodersen  32:05  

Guys, that was all we had for this week’s episode. We’ll see each other again next week.

Outro  34:04  

Thanks for listening to The Investor’s Podcast. To listen to more shows or access to the tools discussed on the show, be sure to visit stage.theinvestorspodcast.com. Submit your questions or requests of guests. appearance to The Investor’s Podcast by going to www.asktheinvestors.com. If your question is answered during the show, you will receive a free autographed copy of the Warren Buffett accounting book. This podcast is for entertainment purposes only. This material is copyrighted by the TIP Network and must have written approval before commercial application.