Status Update on Real Estate Development

A while back I told you about my investment in foreign real estate. Now it's time to see one more step: the conclusion of the construction.

Voila. It's a beautiful construction, thanks to the clever design, effort and sweat of my investment partners at Squadra Arquitetura.

Now the numbers.

The house as it is now cost us more than originally planned, for various reasons that don't matter much here. All told, it was about 32% more than planned. This will certainly eat into our margins.

The good news though is that we raised our asking price a bit. If it goes for our current asking price, we'll be profiting 59%, which is less than the 98% I originally mentioned, but still above our minimum of 40%. So, the margin of safety is there.

Anyway, I'll be posting a final update here when the deal if finally settled. If you want more details, take a look at Squadra Arquitetura's blog (in portuguese only).


Why Does Warren Buffett Buy Entire Companies?

This might be obvious to some, but Warren Buffett buys whole companies for different reasons than the average CEO does. The average CEO is concerned about building empires, pleasing their egos, diversifying, expanding market share, etc.

Warren Buffett simply wants to make more efficient use of capital. That's it. By buying companies outright, he's essentially unlocking the free cash flow (what he calls "owners earnings") and making that available to his holding company, so that it can more profitably be employed in other businesses or used to buy shares of public companies.

Free Cash Flow

Let me explain in more details. A portion of earnings that a company retains (retained earnings) is not available (free) to be taken by the owners or paid in the form of dividends. Some of that is needed to re-invest in the business: buy new equipment, hire new people, train the workforce, invest in a brand new computer system, build a necessary office in a foreign country to support the business there, etc. After all re-investment needed to support the business is accounted for is when free cash flow or owners earnings appears.

But most companies don't pay out as dividend their entire free cash flow. They retain more earnings than is necessary, to have reserves for a rainy day.

Warren is after these reserves, which he can more ably allocate within his holding company than any single company could within itself.

But why wouldn't Buffett buy lots of shares, take a board seat and simply force the company to pay out all its free cash flow as dividends? That wouldn't be efficient from a tax perspective due to double taxation in the corporate structure. So, the alternative is to buy at least 80% of companies and consolidate their assets on Berkshire's balance sheet.

How Can Small Investors Benefit?

The rest of us who can't afford to buy their own conglomerates still has options. It has been shown that following Buffett's move -- even 30 days after the fact -- can still provide enough of a return to beat the market average over long time periods.

Current Opportunities

One current opportunity is to buy out-of-favor Kraft (KFT). Buffett purchased it last year for around $30 per share. It's currently trading for $26. So, if you believe Buffett will be proved right once again, buying below his entry point makes a lot of sense -- you'd be getting an edge over Buffett himself!

Disclosures: I own shares of KFT.


Selling Short

Long-term investors typically don't use a lot of short selling in their strategy. The reason is simple: investing is about being lazy, letting the investment work for you, and about the long-term. While going long doesn't require that one ever sell -- in fact, if one goes for solid dividends payers, then holding on forever is the master plan -- short selling requires that at some point one reverses course and buys back to cover.

However, that doesn't mean that savvy investors can't use short selling as a way to enhance returns, especially if one follows a few rules.

Short Term

Selling short shouldn't be fire and forget. It requires some more work, because at some point one needs to buy it back -- unless, of course, the company is going for total bankruptcy, which is great if you can spot that before everyone else. But typically, you want to get out of the investment before then, to avoid surprises such as delisting and trade halts which could mean you're still responsible for buying back at some point, but now you don't know when.

So, sticking to a few months is probably best and will help you sleep at night.

Margin of Safety

As with going long, in short selling one should require a margin of safety. The price of the security must be so unbelievably high compared to its value that the situation becomes unsustainable in the long run.

How much is enough? That's up to the investor to figure out, but I start with a minimum of 100% -- twice my estimated value. That's because smaller variations could still be errors in my calculation or simply a sustainable premium the market pays for some securities, which can be unlikely to revert to my estimated value in the short run.

Debt Laden

A company that has a lot of debt can quickly get into trouble. Of course, debt doesn't guarantee a company's performance will turn sour -- debt magnifies the positive side too -- but to be a candidate for shorting on my list, it must have a lot of debt. The reason is that debt-free or low-debt-to-equity companies can always fire staff, sell assets or stop producing and reorganize without having creditors go knocking on their doors.

Debt forces interest payment which forces a company to scramble to find revenues. Pressure from creditors during bad times can be a killer. So look for companies with high-debt-to-equity, especially if it's tied with the next two criterias.

Asset Intensive

A company that requires heavy investments of capital to make money can be a terrible investment. Companies such as airlines and some manufacturers that need to constantly renew their assets tend to need a lot of external capital to grow which typically comes from straight debt or dilutive equity offerings. Either way these companies are good starting targets. But that alone doesn't make a company a short candidate; it only makes it a harder job for management.

Poor Management

This is probably the most important reason to sell a security short. And it can also be the hardest one to evaluate. Poor management is the quickest way to lead a company to financial ruin.

I have talked before about how to judge a company's management objectively. These reasons still apply. Especially important is to pay attention to management's candor. Are the quarterly conference calls short and hurried and lacking in details? Do they get even shorter and more lacking when times are bad? These can be terrible red flags.

Another thing to look out for are lots of related parties transactions. Does management employ services from companies or third parties related to them, such as friends, cousins, parents, children and even spouses? A lot of that can be legitimate, but when you find this sort of thing going on in a bad apple, it's typically a magnifier of problems, so make sure to investigate the SEC disclosures regarding related party transactions. The more, the merrier for the short seller.

Never Use Leverage

This is probably the most important rule a short seller should follow: don't borrow money to short a security. Leverage adds a whole new level of uncertainties that are simply too much risk.

First, leverage means you need to pay interest and interest on short accounts are typically a rip-off. Don't give money to the loan sharks of brokerages. Second, leverage magnifies your mistakes. And it's very easy to make a mistake when going short, because, if you followed the margin of safety rule above, you probably sold a company that the market believes has good prospects (high price to value) and markets can stay irrational longer than you want to keep up with margin calls.

In future posts, I may discuss potential short targets as they appear on my radar. For now, I have no short positions other than a few call and put options, which was the subject of another post.


The Two Sides of Muni Bonds -- Part II

This article originally appeared on The DIV-Net on Nov 24th, 2009.

Last time, we talked about what to look for in municipal bonds and their two sides of risk. Now, let's jump right into a few examples.

The safe side

California St. GO Bonds, 2036 4.5% (CUSIP 13062TSB1). These are general obligation of the state of California and pay interest semi-annually at a 4.5% annual rate. As GO bonds, they are backed by the full taxing authority of the state. They're currently trading for around $80 on face value of $100, for a current yield of around 5.6% (4.5%/80=5.6%) and an yield to maturity of about 6%. Just back in July, they traded for $76 and for the last month or two had been trading for $90. Since they're long-term bonds (mature in 2036), the price can fluctuate a lot, based on expectations of inflation, interest rates, and perceived risk.

I found them interesting enough to buy a small amount for $83 back in April. Now at $80, they still seem attractive given the current alternatives.

The risk is that California won't pay its debt. The state is in big trouble, so the risk is real.

The unsafe side

On the dark side, we have revenue bonds whose underlying project went bankrupt.

California Special Tax Diablo Grande, 2014 4.64% (CUSIP 958324CF0). At first glance, this seemed like an interesting opportunity. It's due soon, less than 5 years out, and is currently trading for $62, which means a current yield of over 7% tax-free and an yield to maturity of over 16%.

But consider the risks. These bonds are backed up by a special tax imposed on the Diablo Grande community, a new planned development in California expected to be home to between 5,000 and 10,000 families, businesses, club houses, winery and golf courses. However, due to various legal disputes and the housing downturn, only 400 houses have been built to date. Over 70 of them have been foreclosed. No businesses operate there yet other than the golf courses.

The downside protection is that the state can foreclose on a property that doesn't pay its special taxes. However, there can be no assurance that people won't simply walk away from their devalued properties. If there aren't enough people paying the taxes, the bonds will default.

The developer of the community went bankrupt last year. Recently, a new buyer stepped in and agreed to turn around the operations and re-open the then closed golf courses and club houses. According to local news, the site is operational again, but still there aren't many families and businesses paying the special taxes that support the bonds.

The bonds currently trade for $62 and have been as low as $39 during bankruptcy. The MSRB site does not show any special material events, so I assume the interest is still being paid.

This is one case of high-risk high-reward investment. For the time being, I'm not investing in these bonds until I can confirm how much tax income is available to support the interest on the bonds. A call to the underwriter is in the cards as my next move.

Important note: In investing, there's no such thing as a true safe investment. So, when I classify munis into "safe" and "unsafe", these are both relative terms. It's very possible that "safe" bonds get defaulted on.

Disclosures: I own 13062TSB1 at the time of writing.