Written by Gary Smith
What really matters is the cash generated by stocks, real estate, and other investments.
Stock prices often fluctuate wildly from month to month, day to day, and 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 – buy low, sell high, and repeat.
Sadly, it’s much easier to identify past ups and downs than it is to predict future ups and downs. Study after study has confirmed how difficult it is to time the market. To make matters worse, the attention to this price zigzag has lured many people into investing in Beanie Babies, NFTs, and other foolhardy collectibles in hopes of quickly reaping profits for even bigger fools. .
Value investors think differently.
Value investors think differently. Potential buyers of privately held companies typically focus on the revenue the company will generate. Stock investors should do the same. The intrinsic value of a privately held company or publicly traded stock is the present value of the income it generates. Therefore, value investors focus on a stock’s current and future dividends, share buybacks, earnings, and free cash flow. Because these things really matter.
Value investors do not try to predict whether tomorrow’s stock price will be higher or lower than today. If the price drops, you may buy more instead of regretting your purchase. Warren Buffett writes:
As for my personal preference, I will buy the burger for the rest of my life. When the price of hamburgers drops, the Buffett family sings a “Hallelujah chorus.” We cry when the price of hamburgers goes up. For most people, it’s the same for everything they buy in life, except stocks. When stocks go down and people can get more for their money, people don’t like it.
real estate reality
The same logic applies to other investments such as real estate. A recent widely circulated Zillow (Z) report concluded that the national 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, “Affordability in the housing market is so bad that Zillow says it will take 13.5 years to break even on purchases made after July.”
The biggest benefit of buying a home is that homeowners don’t have to pay monthly rent.
Rising mortgage rates are certainly hurting the housing market, but Zillow’s report is conceptually flawed, focusing on home prices and ignoring the implied income of homeownership. Therefore, it is completely misleading.
Zillow’s “time to profit” calculation is required for home buyers to sell their home for more than they paid, taking into account mortgage interest, maintenance fees, and closing costs. This is an estimate of the number of years. What about saving on rent? The biggest benefit of buying a home is that homeowners don’t have to pay monthly rent. Housing affordability depends on whether it’s cheap to buy or rent a place to live, and Zillow completely ignores that.
I was particularly interested in Zillow’s analysis of the Indianapolis, Indiana area because it featured prominently in a Brookings study my wife and I conducted in 2005. One of our main conclusions was that all real estate is local: the Indianapolis housing market. It’s very different from New York or Boston. This new his Zillow report concludes that buying a home in Indianapolis is a terrible investment because it will take him 21 years to recoup the cost. A 2005 study came to the exact opposite conclusion, taking rent savings into account and buying a home in Indianapolis is a great investment. Let’s see if that still applies.
One of our examples is a 3-bedroom, 3-bathroom, 1,912-square-foot home in Fishers, Indiana, a suburb of Indianapolis. At the time of our study, Fishers had a population of approximately 50,000 people and a median household income of approximately $100,000. Money Magazine ranked Fishers among the top 50 places to live in the United States in 2005 and has continued to rank Fishers among the top 50 places many times since. In 2017, Fishers was rated No. 1 in the country. In 2019, it was ranked 3rd place.
The home was purchased on April 27, 2005 for $135,000 and rented on June 1, 2005 for $1,250 per month. It hasn’t been sold since it was purchased in 2005, but Zillow currently estimates it can be rented for $2,074 ($2.99) per month. % (annual increase since 2005)), or sold for $320,400 (annual increase of 5.2%). Below is the latest cash flow calculation using a 20% down payment and a 7.7% mortgage rate.
After-tax housing dividend for the first year of 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 final amount (the “Housing Dividend”) is the first year’s net income of $2,274. A homebuyer doesn’t have to wait 21 years before reaping the benefits. They are profitable from the first year. A first-year home dividend of $2,274 on a down payment of $64,080 results in an after-tax return of 3.5%. If your rent savings and non-mortgage expenses increase by 3% per year, your long-term after-tax return will be 12.5%. Using a discount rate of 6%, the present value of the cash flows is $638,460.
Zillow’s conclusion that buying a home in the Indianapolis area is a terrible investment is completely wrong. Because he made the fundamental mistake of ignoring the main economic reason for buying a home.
This is a timely reminder of the seductive appeal of the (usually futile) attempt to predict future prices and determine whether an investment will be profitable. Value investors know that cash is king. They focus on 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 papers and 17 books, most recently The Power of Modern Value Investing: Beyond Indexing, Algos, and Alpha ( Palgrave/Macmillan, 2023).
Read more: Betting on Wall Street’s market predictions predicts portfolio problems
MORE: How 46 categories of stocks, bonds and other investments will perform over the next 10 years, according to BNY Mellon
-Gary Smith
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11/28/23 1607ET
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