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Articulate optimists: A caution for investors

Investing in the “next big thing” can be as satisfying as making a 10-foot putt on a rough green....

Investing in the “next big thing” can be as satisfying as making a 10-foot putt on a rough green.

Unfortunately, high yield usually means high volatility and risk, and therefore investing long-term seems smarter.

That’s why in 1994, Long-Term Capital Management LP (“LTCM”) was created – a hedge fund known for, well . . . it’s in the name – long-term capital management. LTCM’s board included Myron S. Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economic Sciences for a “new method to determine the value of derivatives.”

Long-term, however, in this instance meant 1994 to 1998. After initial success of annual returns of up to 43 per cent, the fund went bankrupt due to high leverage and exposure to the 1997 Asian financial crisis.

This kind of event is frustrating for any investor and reminds us that the market is cyclical.

It also makes one wonder if perhaps it’s better to follow great leaders who are articulate optimists. They are bold, have financial leverage and early success, and appear to be visionaries who can predict the future. But, can we trust them?

Remember Enron?

Before Netflix, the U.S.A.’s largest energy trader diversified by investing in a broadband internet service that would provide viewers with the Video on Demand (VoD) convenience we all enjoy today.

That company was Enron, and in January 2000 it promised investors its new proprietary technology would allow them to provide such services. More than that, they promised to create a burgeoning market for trading space on the high-speed, fibre-optic Internet network.

Former chief executive Jeffrey Skilling, an articulate optimist who advocated the use of inflated market value, made exaggerated promises to shareholders about a technology and a market that never quite materialized.

For a host of reasons including logistical issues in operating the broadband unit, unethical business practices and a massive accounting scandal, Enron went bankrupt in 2001. The company collapsed when its own stock price could not hold up all the off-balance-sheet debt crafted through “creative” accounting.

Leaders, including Skilling, went to prison and new laws were written such as the enactment of the Sarbanes–Oxley Act of 2002, setting new or expanded requirements for all U.S. public company boards, management and public accounting firms.

Many will remember, or perhaps will have even lost money because of Enron, and would expect that between more regulation and the resulting prison sentences, the future wouldn’t see this kind of investing scandal again. But as they say, history has a way of repeating itself.

More recently, we have Theranos

This year, Elizabeth Holmes, the world’s youngest female self-made billionaire, is going on trial on nine counts of wire fraud and two counts of conspiracy to commit wire fraud for allegedly distributing blood tests with falsified results to consumers.

Theranos, her health technology start-up, once valued at $9 billion, went bankrupt in 2018 after the shortcomings and inaccuracies of its blood-testing technology, and Holmes’ alleged attempts to cover it up, were exposed.

Investors lost millions.

Similar to Enron’s broadband, the technology Theranos promised simply wasn’t there, yet company leaders made inflated promises and inaccurate claims to lure investors.

If you think this is a recent problem, think again.

In the 1920s, Goldman Sachs’ charismatic leader Waddill Catchings made disproportionate bets and wiped out a generation of wealth-building for the company at the worst possible time – heading into the Great Depression of the 1930s.

He, too, was armed with leverage, optimism and believed he could foresee the future.

The real numbers matter in investment

So where does that leave us now and what do all these leaders have in common? Such leaders use numbers as a drunkard uses a lamp post: for support, not illumination.

The real estate industry, unfortunately, also has leaders like that. Leaders who look at the pro-forma and tweak assumptions to support their decisions to proceed. As long as the prices go up, they get proven “right.” But such articulate optimists armed with financial leverage and early success can become highly damaging to their companies and investors.

How then, should we choose to invest in real estate companies? I recommend focusing on three things in this particular order:

  1. The people. Trust your gut, if you have doubts about trusting the person, pause. Enron did teach us something useful in that just because what they did was technically legal, it was not good for investors. If you cannot trust the person behind the investment, don’t invest because they will always find a way to re-interpret a document, or reality.
  2. The project. What exactly are you buying into? Do you believe in the end product? The business at its core is very simple, deliver a solution to a perceived problem and customers will buy it. In real estate, it means delivering the right type of real estate for the time and the place.
  3. The numbers. The world cannot be understood without numbers. Even the most trustworthy people with great vision for an amazing project must have the numbers to back them up. And numbers better be used to illuminate.

Investing well means we must suffer the pain of discipline or the pain of regret.

The purpose of investing is to generate yield, make profits and grow your wealth.

“Having fun” is not the purpose. Fun is what you can buy after you make the profits.  In the end, great investments require research and can be mind-numbingly boring, and that’s just fine.

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