22 Feb 2016

The Unbearable Lightness of Investment Decisions: When 1.0% more is a deal killer

Adam Geha

22 Feb 2016

positioner

By far the most enjoyable part of my life as a professional investor is the quiet, exquisite, sometimes agonising wrestle with what I call the "unbearable lightness of investment decisions."

How, for example, do you decide when a meager one per cent increment to the purchase price of a property should be a deal breaker? This is hardly an academic question since investment decisions are frequently fraught with such impossibly delicate ("unbearably light") questions. 

Surely one per cent more does not turn a good deal into a bad deal? On the other hand, unless this inflection point exists somewhere, you can use the "one per cent doesn't matter" logic ad infinitum to defend any price.  

And since property negotiations so often occur on or around this inflection point, investment decision making - to misappropriate the words of T.S. Eliot - is frequently an "infinitely delicate, infinitely agonising thing."

What I can say for sure: if you aspire to be a great investor, you have no choice but to grapple with this "unbearable lightness." You must face it, embrace it, even learn to enjoy it - for if you choose to look away, it's only a matter of time before you are ambushed and crushed.

Three times in my career as a fund manager, I have come across experienced property investors who consciously chose to turn the other way, relying instead on bravado and glib rules of thumb:

1.  The CEO of a listed fund manager with over AUD 2.0 billion in real estate assets once told me in a meeting: "The guy who pays five per cent more for the deal, always wins."

2. The head of capital transactions for a USD 100 billion institutional investor once told me: "We have a 'bid to secure' policy. Once we've decided that we want to acquire an asset, we do whatever it takes to secure the asset."

3. A flamboyant high net worth investor once told me: "The one thing that my father taught me is that a good deal doesn't stop being a good deal because you have to pay an extra five per cent".

These formulations are seductive because they substitute certitude and conviction for the "unbearable lightness" - but it's a Faustian bargain that will ultimately leave you bankrupt.

Here's what happened to the three investors in question: the first was sacked after investment returns suffered and the share price of his company plummeted; the second was broken up and sold after suffering investment losses and the third declared bankruptcy.

Which straw will break the camel's back may be an impossible question to answer definitively, nonetheless it is the lot of the professional investor to constantly grapple with this question.

To lend weight to the straw, here is what I've found helpful when considering whether to pay an extra one per cent for a particular property:

  1. Get your head out of the spreadsheet. Financial models are easily manipulated - assumptions can all too readily be tweaked to compensate for the impact of a one per cent increase in price, so that returns appear unaffected. (For this reason, it's important to rigorously police all deviations from standard assumptions. At EG, we do this through PRISMS®, which provides a comprehensive list of all non-standard assumptions adopted by the model, before assessing the resulting returns.)
  2. Ask emotive questions, such as the one I recommended in my blog: The One Killer Question You Must Ask Before You Make a Major Investment Decision.
  3. Adopt the methodology of your optometrist. When my optometrist is trying to finely graduate the prescription for my eye glasses, he iterates to the right answer by repeatedly asking me to look through different lenses and asking me: "Better or worse?" I've learnt over the years that this method also works when grappling with the "unbearable lightness". 

Rather than debating the impossible question of whether an extra one per cent is justifiable, simply ask the killer question: "At the new price, is this deal better or worse than XYZ deal?" Ideally, XYZ deal should be the last deal your team approved for acquisition so that it's fresh in everyone's mind. If your colleagues respond by saying that both deals are great, reframe the question to fry any fuzzy thinking: "If we only had enough funds to do this deal or XYZ deal, which one would you choose?" 

As your colleagues grapple and debate this question, a consensus typically emerges. If you find the team still muddled and uncertain, embrace the "unbearable lightness" and persevere. Introduce another deal, this time ABC deal, ideally the last deal your team narrowly refused. Ask again: "Is this deal better or worse than ABC deal?" Repeat this process until clarity emerges.

There's no easy way out of the wrestle with the "unbearable lightness" ... wrestling with lightness is no easy thing to do. But here's the good news: wrestle occasionally and it becomes bearable; wrestle routinely and, much like a good workout, it begins to become enjoyable.