Saturday, January 28, 2017

Perception-Based Investments

Investments based on perception of the value of something are usually bad investments.

What does a vintage Ferrari, a bar of gold, pork-belly futures, antique coins, antique stamps, a mini-mansion, a bitcoin, and a share of "dot com" stock all have in common?   They are perception-based investments.

In a previous posting about mistakes small investors make, I mentioned off-hand that perception-based investments are a sucker's bet.   And I realized as I typed this, that it was a profound statement that covered a host of areas where people get hosed.

What is a perception-based investment and how can it be characterized?   Well, a simple definition is that it is not really an investment in the first place, but rather something you buy whose value depends on what other people think it is worth.

An "investment" is something that earns money for you in addition to having a perceived value.  It could be a savings account paying interest, a stock paying dividends, or a stock with retained earnings.  It could also be a house or apartment that you don't live in, but rent out at a profit.  In short, it is something that generates income by itself, regardless of the value of the thing as perceived by others.

For example, I buy a duplex for $100,000.   I rent it out for $1500 a month, which with taxes, insurance, mortgage, and other expenses, yields me about $100 a month in profit.   Since I only put $10,000 down on the deal, my "rate of return" on my investment, in terms of income is about $1200 a year, or a 12% rate of return.   If I had paid cash for the unit, I would clear $1000 a month after expenses, or about $12,000 a year, for a rate of return of 12% again.  I am making a profit - income - from the use of the unit, not from the perceived value of it.

Now take my friend.  He buys a condo for $100,000 and hopes to "flip it" for $150,000 in a few months or even a year.  He does not even bother renting it out, as it is "too much hassle".   He is banking on the perceived value of the property increasing by $50,000 by the time he sells.  And in a market where the media is going haywire saying Real Estate is a license to print money, he might very well win.  As it turned out, perceived values tanked, and he ended up bankrupt.

For the reality investor, however, the odds of going bankrupt are far less.   Even with real estate values dropping, I am still making money at $100 a month, like clockwork.   Over a few years, I make more money than my friend had hoped to gambling - and that is all perceived value investments are - gambling.

Of course, it worked out for me both ways.  I made the rental income for a decade, depreciated the property on my taxes, and then sold it to someone else whose perceived value was higher than mine.

And by the way, my perceived value was based on the amount of money I could get in rents, minus expenses.   At $100,000 this duplex made sense.  At $250,000 it was nonsense - but others perceived  it to be worth more.  As a reality-based investor, my perceived value of the property was far less, and thus it was a lot easier for me to determine when perceptions went off the scale.

And that is the problem with perceived value investments - perception can be skewed and distorted by the market.   We call them "bubbles."   People can hype investments, they can talk them up on financial shows, they can create psychological pressures to drive up perception-based values.   They can use shills in the audience, whether at a timeshare sales pitch or an auction, to drive up perceived value of what in reality is just a fungible commodity.

Consider other perceived value investments, or more correctly named, purchases.   Old Ferraris were bid up in price in the 1990's as dot-com millionaires all wanted to show off their wealth.  The dot-com bubble burst and the price of old Ferraris went down - dramatically in some instances.   What happened to make a car worth a million dollars one day and only a few hundred thousand the next?

Well, the basic problem with perceived value investments is that they are based on the law of supply and demand as well as perceived scarcity of the item in question.  If a car is a "collector's item" by dint of being old, it may command a higher price.   If it was one of only a few made, maybe even higher.  It if was owned by Steve McQueen, well even higher, as they aren't making cars owned by Steve McQueen anymore - and never will.

Other, lesser cars, are available in larger numbers.  That old Chevelle you have in your garage may or may not be worth much - they made a lot of them.   And if you "modded" it, it may be worth less.  A four-door post sedan with a six cylinder and two-speed automatic isn't going to be worth much.   A coupe that has been made into a "tribute" 396 SS might be worth something, but not as much as the original.

Of course, if prices go up high enough, people will make new ones.   There is a famous Ferrari that was wrecked while racing and the parts from that car ended up in the hands of three people.   Each "rebuilt" the car from the parts they had, and now three Ferraris are running around with the same serial number.   For lesser cars, this is far easier to do.   If you could find the data plate from my  1965 Mustang (which was about all that was left of it, when I got done with it) you could literally rebuild it from the ground up, even producing a "numbers matching" 289 V-8.  It isn't hard to do, if the money is on the table.

But supply usually isn't the problem, demand is.   People get tired of collector cars and when the economy takes a downturn, 4,000-lb paperweights are the first thing to get sold - and everyone sells at once, depressing the market even further.

An old car can't make you money, unless you rent it out to the movie studios as a prop.  It just sits there and you hope that someone else will pay even more for it down the road.  Poor people obsess about older cars, thinking they are great investments.  They rarely are.

Gold has the same problem.  It will never earn interest, it will never pay a dividend, it will never generate profits.   You have to hope that its perceived value increases over time, and as I have noted before, it is a fear metal that goes up in value in response to fear of weak markets.  Over time, however, markets always recover and stocks go up in value - since the dawn of time.  So gold, even though it may peak in value from time to time, will go back down also, sometimes wiping out "investors" in this inanimate object.

Some stocks are little more than perception-based investments.   A company, such as a dot-com company, that sells stock and generates no profits and no dividends, is little more than a perception-based investment and as a result, I do not recommend these.   People buy these types of stocks based on the "next big thing!" mentality, but sometimes even if it becomes the next big thing, it rarely pans out.   As Nevil Shute Norway noted in his book Slide Rule, people who invested in his company Airspeed ended up getting their investment back, after decades without dividends, but only if they had hung onto the stock.   If they sold in the interim, they would have lost their shirts. And the only reason the investors at the end got paid back was that another company perceived the value of the nearly-bankrupt company to be worth something.

Tech stocks are always risky bets.  Few make profits, much less pay dividends.   The only "profit" to be made is based on perception in the market - a perception that is often skewed, as illustrated by P/E ratios of 100 or more.   People are betting the company will be more profitable in the future - and that is gambling, plain and simple.

Compare this to dividend stocks, whose perceived value can be calculated down to the decimal point based on profits and dividends, and you see there is a huge difference.   And that is one reason why dividend stocks outperform non-dividend stocks in the long-term.

Can you make money on perceived value investments or purchases?  Sure.  You can.  You can also lose your shirt.   You can make money at a Casino, too.   Few do.  And the few that do, end up breaking even at best, over time, or losing their shirts as well.  You play this game long enough, you go broke.   Perception-based investments is just buying shit you think someone else will pay more for.  And at best, that is a game of margins.

But yes, it is also true you can also lose money on dividend stocks as well, particularly if you don't do your homework and bet on a company that is paying dividends even as it loses money.   You can lose money on a rental property if the market tanks, the neighborhood goes to hell, or you let vacancy destroy your rental income - or you just pay too much for the property.  But generally, it is harder to do.  Something that earns money generally has a more stable perceived value over time.  And yes, profits matter, even in this wacky new Internet world we live in (No, seriously, back in the 1990's, people were saying that profits were "a thing of the past" and a company's success was measured by how fast it burned through capital - we know how that worked out).

An investment that creates wealth - generates income by actually making or doing something is bound to be a better bet and have a more stable perceived value over time.   Inanimate objects, on the other hand, never work for you, they just sit there - waiting for the time that someone perceives them to be worth more.   And you have to hope that when you need to sell, that the perceived value is more at that time than when you bought.