Stock prices often swing wildly month to month, day to day, even minute to minute. It’s natural to think that the way to make money in the stock market is to time these ups and downs — to buy low, sell high, and repeat.
Alas, it is far easier to identify ups and downs in the past than to predict them in the future. Study after study has confirmed how hard it is to time the market. Even worse, this focus on zigs and zags in prices lures many into investing in Beanie Babies, NFTs, and other foolish collectibles, hoping to sell for a fast profit to even greater fools.
“Value investors think differently. ”
Value investors think differently. Prospective buyers of private companies generally concentrate on the income that will be generated by the company. Stock investors should, too. The intrinsic value of a private company or a publicly traded stock is the present value of the income that will be generated. Value investors consequently look at a stock’s current and future dividends, share repurchases, profits, and free cash flow because these are what really matter.
Value investors don’t try to predict whether a stock’s price will be higher or lower tomorrow than it is today. If the price drops, instead of regretting their purchase, they may well buy more. As Warren Buffett wrote:
To refer to a personal taste of mine, I’m going to buy hamburgers the rest of my life. When hamburgers go down in price, we sing the ‘Hallelujah Chorus’ in the Buffett household. When hamburgers go up in price, we weep. For most people, it’s the same with everything in life they will be buying — except stocks. When stocks go down and you can get more for your money, people don’t like them anymore.
The reality of real estate
The same logic applies to other investments, such as real estate. A recent, widely circulated Zillow
Z,
report concluded that the nationwide average “time it takes to make a profit on a home purchase” is 13.5 years. Fortune magazine’s report on this conclusion was titled, “Housing market affordability is so bad that Zillow says it will take you 13.5 years to break even on a purchase from July onward.”
“The biggest benefit from buying a home is that homeowners don’t have to pay monthly rent.”
Soaring mortgage rates have certainly hammered the housing market but the Zillow report is conceptually flawed and completely misleading because it focuses on home prices and ignores the implicit income from owning a home.
Zillow’s “time it takes to make a profit” calculation is an estimate of the number of years required for homebuyers to sell their home for more than they paid for it, taking into account mortgage interest, maintenance and closing costs. What about are the rent savings? The biggest benefit from buying a home is that homeowners don’t have to pay monthly rent. Housing affordability is all about whether it is cheaper to buy or rent a place to live — and Zillow completely ignores it.
I was particularly interested in Zillow’s analysis of the Indianapolis, Ind. area because this featured prominently in a Brookings study that my wife and I did in 2005. One of our main conclusions was that all real estate is local — the housing market in Indianapolis is very different from New York or Boston. This new Zillow report concludes that buying a home in Indianapolis is a terrible investment because it will take 21 years to recoup the cost. In our 2005 study we took the rental savings into account and came to the exact opposite conclusion — that buying a home in Indianapolis is a great investment. Let’s see if that is still the case.
One of our examples was a three-bedroom, three-bathroom, 1,912-square-foot home in Fishers, Indiana, a suburb of Indianapolis. At the time of our study, Fishers had a population of about 50,000 with a median family income of around $100,000. Money magazine ranked Fishers as among the top 50 places to live in the United States in 2005, and has continued to rank Fishers among the top 50 places multiple times. In 2017, Fishers was rated #1 in the country; in 2019, it was rated #3.
This home was purchased for $135,000 on April 27, 2005, and rented for $1,250 a month on June 1, 2005. It has not been sold since its purchase in 2005 but Zillow now estimates that it could be rented for $2,074 a month (a 2.9% annual rate of increase since 2005) or sold for $320,400 (a 5.2% annual rate of increase). Here are the updated cash-flow calculations using a 20% down payment and a 7.7% mortgage rate.
First-Year, After-Tax Home Dividend in 2023
Rent savings: $24,888
Mortgage payment: –$21,930
Property tax: –$2,284
Tax savings: $6,144
Insurance: –$1,344
Maintenance: –$3,200
Home dividend: $2,274
The bottom line (the “home dividend”) is net income of $2,274 the first year. A homebuyer doesn’t have to wait 21 years to show a profit. They have a profit the very first year. The first-year home dividend of $2,274 on a $64,080 down payment is a 3.5% after-tax return. If the rent savings and the non-mortgage expenses grow by 3% a year, the long-run after-tax return is 12.5%. With a 6% discount rate, the present value of the cash flow is $638,460.
Zillow’s conclusion that buying a home in the Indianapolis area is a lousy investment is completely wrong, because it made the fundamental mistake of ignoring the main financial reason for buying a home.
This is a timely reminder of the seductive allure of (generally futile) attempts to predict future prices, thinking that this determines whether an investment will be profitable. Value investors know that cash is king; they focus on the cash generated by stocks, real estate, and other investments because that’s what really matters.
Gary Smith, Fletcher Jones Professor of Economics at Pomona College, is the author of dozens of research articles and 17 books, most recently, The Power of Modern Value Investing: Beyond Indexing, Algos, and Alpha (Palgrave/Macmillan, 2023).
More: Betting on Wall Street’s market forecasts predicts trouble for your portfolio
Plus: How stocks, bonds and other investments in 46 categories should perform over the next 10 years, according to BNY Mellon
Read the full article here
