A couple weeks ago I had the chance to chat with Moses Kagan. Moses is a real estate investor. His niche is hyper-specific: about five-to-six neighborhoods within Los Angeles, CA.
Moses is a classic deep-value real estate investor. He buys ugly, forgotten and overlooked apartment buildings. He fixes them up, increases rent and generates handsome returns for his investors. Describing his process, Moses says,
“We have an unusual strategy. Our business model is to buy beat-up, old apartment buildings in about five or six neighborhoods in Los Angeles.”
Moses operates in different markets than equity investors. But his lessons have practical application to any asset allocator.
There’s three main themes from my conversation with Moses:
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- Look Where Others Won’t & Have a Variant Perception
- Long-Term Mindset
- Cash Flow, Cash Flow, Cash Flow
Let’s dive in.
Theme 1: Variant Perception on Overlooked Deals
Moses described a ruthless idea generation process. His strategy is simple. He sits down and for hours at a time flips through each deal listing on various websites. Every single one. Is it tedious? Of course. But that’s how you find the great deals.
Moses expanded on this idea in another podcast, saying:
“Every once in a while, I don’t know when it’s going to happen but I know, because I’ve been doing it for a long time, that it will happen. You find stuff that’s mispriced. The more you do and the more confident you are in what the numbers look like, the quicker it jumps out at you that something is mispriced. You get where you start to see the matrix. You have to keep staring at deals after deals. Suddenly you’re like, “That’s a deal.” You run crazy to try to get it.”
Studying every deal enables Moses to capture what matters most: if the deal will work. Through Olympic-like dedication, Moses has built up the experience to be able to tell a bad deal from a good one in seconds.
There are a number of reasons why an idea doesn’t work:
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- High price/square-foot
- Low rent figures
- Bad neighborhood
- Overvalued asking price
One of my favorite write-ups from Moses centered around this idea. Here’s a snippet from his post, The deals I’m most proud of (emphasis mine):
“After all, it doesn’t take a genius to decide to buy a building for $235 / sq ft when it would cost $350 to build it, if the land were free, and everything in the neighborhood is at $350+. The ones I’m proudest of are the deals that we buy on the market, where everyone else had a crack.”
The above quote is a perfect definition of overlooked assets. To generate outsized returns, you have to have a variant perception. A different way of looking at things versus your competition.
Application for Public Equities
There’s a few ways public equity investors can use Moses’ first lesson:
1. Look at unloved Stocks
Begin your search in the bargain bin. You find these on the 52-week low and all-Time low lists. Scan for stocks down 40, 50, 80% off their highs.
2. Develop a Variant Perception
Can you see a future for the company that looks different than the consensus? Does this future make sense? What do you stand to gain if you’re right? How much will you lose if you’re wrong?
3. Turn over all the rocks
Look at every company trading around its 52-week and all-time lows. Put in the work that others aren’t willing to do. Over time, you’ll develop a sixth-sense at what looks cheap and expensive. These incremental time savings add up. That allows you to look at more companies, pass on more bad ideas and arrive at the best opportunity set.
Theme 2: Long-Term Mindset is Required
My conversation with Moses seemed to pull from one thread: long-term relationships. In fact, Moses credits the power of long-term relationships for his success as a real estate investor.
“You really need equity. You really need risk capital. If you ever want to be anything besides a small-time player, you gotta get people to trust you. And the first thing is you need to appreciate how precious that capital is … As a user of capital, you have to understand how precious that capital is. Someone bled for that. Step 1 is acknowledging that you need other people’s capital, and that capital is precious.
You need to honor the fact that someone is trusting you with something that’s precious. No-one is expecting perfection from you. But they’re expecting honesty, your best efforts, and honest results.
If you’re screwing people over, playing one-iteration games, then you burned your investors if you want to do another deal. And by the way, your reputation catches up to you and you’re out of business.”
He also mentioned this in prior podcasts, saying (emphasis mine):
“You’re playing a multi-iteration game. In that game, it’s not trying to screw over the other guy so you win. It’s like, “How do we figure out how to make sure that we both win?” We’re going to keep doing this over and over. We could do better by collaborating. That’s what it comes down to. Think about those people who trust you with capital. Capital is precious in a world where income is a tax for your highest earners.”
There’s first and second-order effects from a long-term mindset in equity investing.
First-order effect: Sticking to your process during periods of drawdowns. Every decision has a consequence (or effect) on something. How you decide to invest is no different. You might not run a fund, have LPs or compliance to worry about — but you have yourself.
Don’t deviate from your investment strategy during periods of drawdowns or contractions. Remember, we’re playing the long-game here. Take a step back — in 20 years will your investment process make sense? If the answer is yes, why deviate now?
Second-order effect: The second-order effect is more powerful, but takes longer to realize. Moses stressed many times that relationships make or break your success as an investor. It doesn’t matter if you’re in equities, private businesses or real estate.
Your reputation follows you. I want to reiterate Moses’ comment (emphasis mine):
If you’re screwing people over, playing one-iteration games, then you burned your investors if you want to do another deal. And by the way, your reputation catches up to you and you’re out of business.”
Yes, maybe you get away with providing less-than-stellar returns to your LPs on one investment. What happens when the next “no-brainer” comes along and you need money to do the deal? That same LP base will remember how you screwed them, and they won’t do business with you.
That’s why long-term relationships are so important. You never know when the next great idea will come around. An idea so lucrative it could make your career.
Markets are multi-iteration games. Mr. Market will always throw another pitch. It’s up to you to stand at the plate with the bat in your hand. And if you go around screwing people, or taking short-cuts to score short-term profits, you won’t get to bat.
Application For Investing
1. Focus on the Long-Term Cash Generation of The Company
A long-term mindset ignores short-term fluctuations in a stock’s price and a company’s earnings. What a company reports in a recent quarter has little (if any) effect on long-term cash flows. As long as the long-term thesis remains intact, a short-term blip in earnings isn’t a cause for worry.
2. Stick With Your Process During Downturns
Buying companies at discounts to their future cash flows doesn’t go out of business. It may go out of favor — but that doesn’t mean your investment philosophy goes out the window. Investing (like business) goes through cycles. Growth outperforms value, value outperforms growth. Fluctuations happen. Drawdowns happen. Can you stick to your process during an inevitable downturn? If you can’t you should rethink your strategy.
Theme #3: Cash Is King, Baby!
Whether it’s real estate or public equities, at the end of the day cash is king. It’s almost relaxing knowing that no matter where we invest, these two factors matter most:
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- The price you pay
- The future cash flows you receive
That’s it. Whether it’s a duplex in the heart of Detroit or a small-cap healthcare stock. It comes down to how much you pay for the future cash flows of that asset.
Moses’ approach to cash-flow producing assets is simple and robust. He uses a couple of metrics:
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- Cap Rates
- Price/Annual Gross Rent
This approach to valuing income-producing real estate properties translates directly to stock investing.
Here’s the Cap Rate formula: Gross Annual Rent (either realized or estimated) / Asking Price of Property.
Let’s use an example: $150,000 property with history of $2,000/month rental income
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- Cap Rate = $24,000 / $150,000 = 16% Cap Rate
In other words, you’re getting a 16% rental yield on that property. Not bad.
The Price/AGR is simply the inverse of the above calculation: $150,000 / $24,000 = 6.25
You’re paying 6.25x historical annual rent for the property. That doesn’t sound bad. You see how well this applies to stock investing. Let’s use an example on Company XYZ. The business produced $2M in operating earnings in 2019 and has an Enterprise Value of $15M. You expect operating earnings to (at the least) remain around $2M. (We use Enterprise Value because we’re thinking as if we were buying the entire company. Debt, cash and all.)
So we use the same two metrics above, but for the company.
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- Cap Rate = $2M / $15M = 13.33%
- Price/Operating Earnings = 7.5
This isn’t new stuff we’re discussing here. But I love applying it to real estate because you see the actual cash flow generation. With real estate you collect the checks. Investing in public companies doesn’t provide an equal, tangible feeling. But the principle remains constant.
Concluding Thoughts
There’s a lot that public equity investors can learn from real estate investors. Real estate investors know the power of cash flow better because they’re first-order recipients of that cash flow. In a way, they live and die by cash flow. Equity investors have the life-line of price appreciation and multiple expansion. No wonder there’s a bifurcation of importance on cash flow.
Regardless of where you decide to allocate capital, these three truths ring clear:
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- Have a variant perception: Look at the world through a different lens than others. If you’re lucky (and patient enough), you’ll find deals other passed.
- A long-term mindset is required: A long-term mindset separates the greats from the average joes. Are you willing to say no to one marshmallow to receive two later? Do you focus on process, not outcome? Can you play the multi-iteration game well?
- Cash is king, baby: Focus on cash flow. Prioritize the long-term cash flow generation of an investment. That’s what you’re paying for. Not the company’s earnings. But the present value of their future free cash flows.
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