GDS Investments July 2024 Commentary

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HFA Staff
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GDS Investments

GDS Investments commentary for the month of July 2024.

“The stock market is there to serve you and not to instruct you.” – Warren Buffett, co-founder, chairman and CEO of Berkshire Hathaway

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Is it true that real estate is the best long-term investment available to the public?

That’s what a  plurality of Americans say in Gallup’s recently published 2024 Economy and Personal Finance survey: “Americans continue to rank real estate as the best investment for the long term among six options. Thirty-six percent choose real estate, followed by stocks or mutual funds (22%), gold (18%), and savings accounts or CDs (13%).”

The only problem: the stock market has been beating the real estate market by a sizable margin for decades. Between 1980 and 2023, the U.S. housing market’s annualized average growth rate was 8.6%. The S&P 500 alone returned over 14% over the same time period.

Still, it seems entirely understandable why people would rank real estate so highly, if incorrectly.

First, real estate is a product that everybody can understand, at least at a basic level. Stocks, by contrast, are not necessarily the easiest asset class for people to grasp. At heart, equities offer a fractional way to own a publicly traded company. It’s a way to get access to the benefits of owning a business without the costs or obligations of being a full owner.

But not everyone understands this clearly. For many people, stock ownership can feel like gambling. The gamification of stock ownership through app-based trading, the increasing popularity of day trading, and the rise of trends like “meme stocks” don’t help to correct this view.

Neither does it help that far fewer people have bought stock than have bought or leased real estate. Somewhere around two-thirds of Americans own some kind of real estate property, usually their primary residence. A similar percentage own stocks, but the vast majority of these are automated retirement accounts, ETFs, etc. that they inherited, got through their employer, or otherwise have little interaction with. The percentage of Americans who have personally bought stock is much, much lower—just over 20%.

Consequently, many people view stocks as a rich person’s investment. Consider: the bottom 50% of Americans own only 1% of stocks and, in aggregate, hold only 19.3% of their total assets in equities, whereas they hold 50% in real estate. The numbers don’t change much for the 50th to 90th percentile of Americans, who hold 23.8% of their total assets in equities and 38.1% in real estate.

In short, people tend to have a better understanding of real estate than of stocks, way more people own homes than actively buy stocks, and most people hold significantly more wealth in real estate than in equities. Taken altogether, the greater familiarity with real estate naturally predisposes people to think of real estate as a better long-term investment.

Second, in some ways, stock ownership is harder than real estate ownership. Even those who understand the equities market can still have a hard time finding success. If the question is what makes the best long-term investment, we must treat stocks as a long-term asset in the first place, but most people don’t. The market is infested with short-termist approaches, if only because most people are not psychologically prepared to deal with equities over the long term.

If you want to be an equities investor, you must accept you're going to put $10 down and, at some point, may have some unrealized losses because the stock price will dip. A long-term investor will weather that downturn because they understand the loss isn’t realized until they sell; and if they continue to hold, the price will come back up (assuming they chose their position wisely). The challenge is that most people are not going to be able to deal emotionally with that level of volatility, so they'll end up locking in the loss because it's too much for them to take.

As Warren Buffett has said, “This imaginary person out there – Mr. Market – he's kind of a drunken psycho. Some days he gets very enthused, some days he gets very depressed. And when he gets really enthused, you sell to him and if he gets depressed you buy from him.” Mr. Market is how most people treat stocks.

That may be why the average holding period (how long someone owns an equity before selling) has fallen precipitously over the past several decades. In the 1950s, the average holding period was nearly a decade. Now, it’s less than a year. Why would anyone even think of stocks as a long-term asset when the average person holds them for such a short period?

By contrast, the illiquid nature of real estate organically extends the holding period. Even when property values dip, it’s more onerous, involved, and time-consuming to buy/sell real estate assets. As a result, far more people hold onto real estate for longer. Once again, this would naturally predispose people to think of real estate as a stronger long-term investment.

So, why has real estate underperformed stocks since 1980?

Indisputably, some people have (and will continue) to earn big rewards in the real estate market, but real estate simply isn’t a better long-term investment for most people. Most people think they understand real estate far better than they genuinely understand it. This follows our theme in last month’s letter: the best capital allocators focus on the forms of capital allocation they know best. Smart investors focus on areas where they have expertise, and they stay away from areas where they are intellectually honest enough to recognize they do not have the expertise.

As for real estate, the market is poised to become even less desirable or successful as a long-term investment. The reason: the cost of credit has risen steeply. From 2008 to 2016, and again during the pandemic, the federal funds rate hovered near zero. Even at the height of its brief increase in 2019, the rate only went up slightly. Cheap credit meant real estate buyers had years and years to enjoy lower mortgage payments, with a greater share of those payments going toward building personal equity in the property. That maximizes the value of real estate as an investment.

Now, however, rates are higher than they’ve been in nearly two decades; and these higher interest rates haven’t even fully cycled through the system yet. Once they do, we will likely see bearishness on the real estate market tick up. High rates will depress housing market activity and make real estate not just less desirable but less profitable for investors than before.

Bear in mind: the 8.6% annualized growth rate in the U.S. housing market between 1980 and 2023 is an average that obscures wild swings. The last time the cost of credit was as persistently high as now was the late 1990s. During that period, property values appreciated only around 2.5% annually—not quite the money-maker for which many would-be real estate investors hope.

A few final notes

We’ve been reading a fascinating book, The Great Depression: A Diary by Benjamin Roth. This read has been eye opening on the theme of how the more things change, the more they stay the same. Roth, working as a lawyer during the Great Depression, took day to day notes about his experiences. His son later found those notes and published them as this diary. One of the most striking aspects of this book has been taking note of what has changed—and what hasn’t.

Specific economic zones, for example, have changed tremendously. At the time of its writing, its setting (Youngstown, Ohio) was a thriving and vibrant commercial center. Today, it is the poorest of Ohio communities, with more than one in three of its residents living below the poverty line. It’s not just businesses that can come and go as the result of massive disruptions; so too can entire communities.

But human psychology and behavior has changed not a whit. Excessive valuations, huge speculation in mergers, buying assets on margin, panic selling—sound familiar? Even the larger economic trends facing the United States are broadly similar. Roth, for example, talked about the fear that certain chains were going to put independent merchants out of business. If today it’s Walmart and Amazon, back then it was Kroger and A&P. Roth also observed how technological developments would make some jobs obsolete while serving as a tailwind in creating or strengthening others.

We’ve also been reading The Cult of We: WeWork, Adam Neumann, and the Great Startup Delusion by Eliot Brown and Maureen Farrell. Often finding success is a matter of avoiding failure, and this book reads like a checklist of what we don’t want in a business.

To be clear, GDS Investments never invested in WeWork; from the start, there were too many red and yellow flags that gave us pause. This book details exactly how bad those warning indicators really were under the surface. To start, the CEO seemed to be obsessed with private market valuation; and with each incremental private offering, the business got repriced higher and higher until it was shockingly out of line with economic reality, especially for such a capital-intensive business. At its height, WeWork was valued at $47 billion (2019). A few years later, after its spectacular collapse, it was valued at just $44.5 million (2023)—a full order of magnitude decrease in value.

Sometimes these kinds of IPOs can still be valuable if we wait until the initial price collapses, which is sometimes called a “busted IPO.” When Facebook went public, for example, its initial offering of $38 per share fell dramatically within days, presenting a great opportunity to buy (at the time). Still, that depends on the business having inherent value, and as this book strongly suggests, WeWork never had the substance to back up the hype. Overall, the book is a profound argument in favor of never buying into the excitement and always scrutinizing the numbers of any investment.

For our part, GDS Investments has always been committed to owning “best in class” businesses that exhibit strong “green flag” characteristics, like high unleveraged return on capital, industry leading market share, shareholder-friendly leadership which manages for the long-term, and businesses with enduring moats and/or those disrupting industries with weakening moats. We will continue our focus on identifying, researching, and acquiring companies that offer the best combinations of quality and value.

As always, I remain grateful to you for your ongoing support.

With warm regards,

Glenn Surowiec

GDS Investments

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The post above is drafted by the collaboration of the Hedge Fund Alpha Team.