Remember that you can have a very successful investment career with a completion rate of less than 1%. Investing is a strange game in that most of what you work on will never actually happen. You need a unique personality to cope with that aspect.
In the gaps between deals, your return criteria are tested and you’ll be tempted to dabble just to do something. Remember the key five from last week and stick with the fundamentals.
When I come across a deal that fits my criteria, there are three questions that I ask myself.
#1 – Why sell?
What’s the vendor’s motivation and why am I being offered this great deal? You can not afford to overpay and hope that leveraged asset inflation bails you out – that’s just for professional investors that use other people’s money.
The huge amount of leverage in our society is creating buying opportunities due to people’s need to repay their debts. Other reasons to sell can be moving cities, relationship breakdown, or change of strategy. I’ve done deals with all these types of vendors.
When I can’t figure out why I’m being offered a deal – I pause.
Things that appear to good to be true aren’t as they appear.
#2 – Calculate your margin of safety
I’m pretty sure it’s a Warren Buffett saying, “price is what you pay, value is what you get”. To get me to do a deal, the price needs to be less than the value. This is mainly because you never get full disclosure and you’ll nearly always end up having to invest more than you expect.
I like to figure out what the value of the asset is an independently as possible. I also value relative to my current, and future, situation. When I’m 60, I suspect that I’ll have different needs than when I’m 40. So I try to take that into consideration. It’s also why I’m fond of Rule #4 from last week (always be able to exit).
If you don’t have the skills to properly value your deals then wait! Acquire the skills, learn the fundamentals about valuation and be patient. Remember that you only have to do a couple of decent deals in your entire life. Don’t dabble.
#3 – What is required for failure?
Most of us do too good of a job convincing ourselves how we’re going to make money.
Take time and consider what can wipe you out. Once you have a list of those items then you can perform research to rule them out, insure against them, or accept that they might wipe you out. Personally, I either rule them out, insure against them, or factor in the cost of mitigation.
You don’t need to be a genius to figure out what can kill you but you will need to spend some mental effort. The largest investments that most of us will make in our lives is real estate and a quick google search can give you a list of items to consider. You can also keep reading my blog as I’ll be laying out the basics for you over the next few months.
On this subject, I recommend Charlie Munger’s book, lots of case studies and practical examples. Spin the deal, and the world, on it’s head and see what that does to your situation.
A practical example of inversion is interest rates.
If you are borrowing significant sums of money that will reset in the next ten years – then what would happen if your cost of borrowing doubled? What if it tripled? Quadrupled? Sounds unlikely? Have a look at historical interest rates – specifically mortgage and prime rates — you need to scroll down a bit to where you can see the figures around 1980.
Be sure to leave room for the unexpected as well as saving capital so you’ll be in a position just-in-case the buyer’s market of a lifetime heads our way. Check out the java chart of the Living Yield Curve and imagine what is going to happen when rates rise to normal levels.