Searching for Value, From Pigs to Property!

Analysis, Financial Planning, Investments, Market Watch

Searching for Value, From Pigs to Property!

13 Apr , 2015

Many may think that successful investment managers are nothing but gamblers, sharks, charlatans, cowboys and crooks. These are individuals who use the concept of the “market” as an imaginary platform to showcase their so-called “skills”. Although one will come across the odd con-man, both on Wall Street and in Southeast Asia, who will have you believe that they are able to make obscene amounts of money using some sort of complicated “strategy”, these claims will more often than not be completely duplicitous. There are, however, individuals who exist, successful investors who have been able to consistently produce very good returns on the investments they manage, not through some sort of mythical sorcery, but through the ability to calculate and identify the “true” or intrinsic value of an asset or investment.

When I was growing up I would constantly ponder the wealth gap. Every day I would try to ascertain why some were wealthy and others were not. Was it because the wealthy were smarter? Luckier? Perhaps beneficiaries of generational wealth and opportunity? I remember my parents once telling me about a family friend of theirs, a local farmer in our district in South Africa, who grew up very poor, yet eventually became one of the biggest land owners in the Free State Province. As a young boy he had purchased a few pigs, fattened them, and sold them at a profit. He then re-invested the profit into the purchase of more pigs, and speculated on the livestock market until he made what he thought was an optimal profit. He always believed he had a very good idea of what the “true” price of an adult swine was, and traded accordingly. This had a profound influence on me because I had then realized that it was possible to enrich oneself, not only through hard work and toil, but also through a much deeper understanding of an item’s value.

To many, modern day investment icons would be the likes of Warren Buffet, Benjamin Graham and George Soros. Buffet, known for his frugality despite his immense wealth, is a disciple of Benjamin Graham, who is considered the father of value investing and calculating the “true” value of a tradable asset. George Soros, who in 1992 made 1 billion dollars on the currency market in a single day, applies his own theory known as “reflexivity” to ascertain true value.

A very basic method of calculating an asset’s intrinsic value would be to simply discount the cash flows it would produce over a certain period of time. A simple example would be the case of buying property for the purpose of renting to a third party to generate income. If you had the option of buying a property for $100 000 today, and you knew the market rental charged for similar properties was $2000 per month i.e. $24 000 per year (for this example we are excluding any initial outlay, such as an upfront deposit), and you are able to obtain a mortgage at 8% interest per year, considering you plan to own and let the property for a period of 10 years, you could calculate the intrinsic value as follows: divide the cash flows received per year ($24,000) by the compounded rate of interest you would have to pay per year (8%) and add the results for a period of 10 years (24 000/(1.08)10+ 24000/(1.08)9+24 000/(1.08)8… etc.), eventually you will end up with a value of $ 161 041, which is essentially the intrinsic value of the property today.

Therefore, if you know the value of your future cash flows in today’s terms is $ 161 041, and the property costs $ 100 000 today, then intuitively you would know that purchasing the property would yield a profit of $ 61 000 in today’s terms and you would possibly be thinking of purchasing it (remember that we have not accounted for any capital appreciation on the property itself, and we are assuming that you would be able to sell the property for $100 000 in ten years). This is fundamentally a very basic example. There are, however, many methods which individuals use to interpret and calculate value, each implementing unique qualitative and quantitative variables. Every successful investor might utilize a different method from which their decisions are made. If every person made decisions based on the same assumptions then we would have no winners and no losers. My advice is to read about and research a few successful investors, learn more about their decision making processes, and perhaps apply them to the way you do business or save money. More often than not you will find that their approach is extremely academic and meticulous. Ignore fast-talkers, salespeople and gamblers. Rather seek the advice of a qualified financial advisor or analyst.

Written by Sven Roering, Total Wealth Management