I’ve just finished running my annual workshops with The Fifth Person teaching about cycle based investing. The workshops were full day workshops conducted over the weekends. While tiring, they are also incredible fun to run as I share about the different cycles that dominate our economy.
Q3 hedge fund letters, conference, scoops etc
Cycles Matter!
One thing that continually impresses me time and time again is how prevalent cycles are and how much they matter when it comes to investing.
Most people are familiar with business cycles and maybe the property cycle. Less well known but equally important is the credit cycle i.e. the growth of loans within the economy.
Cycles affect valuations
Valuation models (discounted cash flow, P/E etc) are essentially projections into the future. You can’t do valuation work before thinking about where are we are in the cycle and how that might affect future demand.
As Howard Marks is fond of saying, trees rarely grow to the sky and few things ever go to zero. Growth rates do not go up consistently and rarely revert back to terminal growth rates.
You can understand this enough easily in context of a common enough asset class like REITs. For example, rents will not continually keep rising for office space simply because high rents will attract either:
1) Substitution – people moving out further from the central as high rents do not make it economical to continue renting within the central district
2) Additional supply – high rents will motivate developers to develop more office space to capture this increased rent
So while rents can keep rising in the short to medium term, they cannot keep rising simply because the market will react. If you know that there is a huge wave of impending supply, it makes sense to be far more conservative in your estimated valuation.
Even the most competent of manager will find it challenging to maintain positive rental reversions in the face of huge supply shocks.
Demand is hard to predict…
One thing which I continually emphasize during the class is that most people tend to focus on demand which is tough to do accurately and repeatedly.
Unfortunately, predicting demand is notoriously difficult simply because consumption preferences change. There are so many potential variables that can affect consumption especially when prices rise.
For example, in the case of the recent Grab-Uber merger, consumers reacted furiously to the removal of promotional codes to finding new substitutes for ride hailing or reverting back to other forms of transportation.
Supply is easy to forecast
On the other hand, impending supply is often easy to see simply because it takes time to come online. Property is the easiest to forecast simply because of the long lag time involved.
Think about it – it takes years for a development to go from conception to handing over to the end user.
In the case of en-bloc sales which have dominated that market of late, developers will have to take control of the old properties that the residents have to move out from, relevant planning approval must be obtained, the property has to be demolished and reconstructed and so on.
This process can take anywhere from 3 to 5 years depending on the complexity of the project involved.
Applying this to looking at REITs
You generally want to avoid situations whereby you have a huge impending wave of supply coming in that will depress rents.
Many REITs actually provide useful supply forecast that can be easily obtained in their investor presentations.
In the case of Far East Hospitality Trust, this is a snapshot of their forecasted supply graph from 2013.
The challenge in many cases is that estimated demand does not materialize as expected – and when you have a huge surge in supply that may even be more than initially forecasted that can lead to decreased revenues and for REITs – it means reduced distributions to unit-holders.
Article by Jun Hao, The Asia Report
