Even Before The Pandemic Fades, The Death of the Corporate Office Appears Greatly Exaggerated

During every recession trophy assets go on sale in the equity market but sometimes aren’t noticed because most everything looks cheap and the headlines are so ugly. Commercial real estate has served investors well for decades but the pandemic is putting landlords on shaky ground in the near-term as rent collection percentages sink from the high 90’s rate we are used to seeing.

I have long favored investing in real estate by way of the public markets and while these holdings are not doing well right now, I firmly believe the asset class will regain its dominance in time and that certain assets that I did not own coming into 2020 can be had now at amazing prices. I am focusing on office space in prime markets like New York these days, as the media would have you believe that the corporate office will never be the same again and working from home is the new normal. The stock prices are indicating a similar narrative, with share prices down 40-50% from 52-week highs.

Let’s not get too carried away. In fact, there are already signs that my longer term thesis (that workers will largely return to the office, though there will be more flexibility to work from home occasionally) is likely to come to fruition. For instance, on Monday Vornado (VNO) announced that they leased 730,000 square feet of office space to Facebook in New York City. While the press is reporting that tech companies are leading the path toward letting employees work from home well into 2021, they clearly have every intention of bringing people back when it is safe to do so. If you are investing based on the narrative that people are fleeing cities for the burbs (because if offices are not downtown, why be there?) and that the tech sector is going to lead this shift because software engineers can work from anywhere, please ask yourself why Facebook is leading this much space in the middle of NYC.

Even though we are really only in the early innings of the working from home movement, there are already business leaders who are questioning whether they can maintain the same levels of productivity, training, and problem solving when teams are scattered across a city or state. A recent Wall Street Journal article entitled Companies Start to Think Remote Work Isn’t So Great After All framed the issues wonderfully. Below are some excerpts:

“Four months ago, employees at many U.S. companies went home and did something incredible: They got their work done, seemingly without missing a beat. Executives were amazed at how well their workers performed remotely, even while juggling child care and the distractions of home….. No CEO should be surprised that the early productivity gains companies witnessed as remote work took hold have peaked and leveled off….. because workers left offices in March armed with laptops and a sense of doom. It was people being terrified of losing their jobs, and that fear-driven productivity is not sustainable…”

“In San Francisco, startup Chef Robotics recently missed a key product deadline by a month, hampered by the challenges of integrating and testing software and hardware with its engineers scattered across the Bay Area. Pre-pandemic, they all collaborated in one space. Problems that took an hour to solve in the office stretched out for a day when workers were remote, said Chief Executive Rajat Bhageria.”

“Projects take longer. Training is tougher. Hiring and integrating new employees, more complicated. Some employers say their workers appear less connected and bosses fear that younger professionals aren’t developing at the same rate as they would in offices, sitting next to colleagues and absorbing how they do their jobs.”

Perhaps my favorite part of the article was a discussion with the CEO of a company called OpenExchange, which has seen plenty of efficiency problems with remote work:

“Workers on the company’s European team said they could benefit from some in-person interaction during this time of huge growth at the company. So in late July, OpenExchange is renting a house in the English countryside, with about 15 bedrooms, so many of its employees can live and work together, while still distancing. It’s important to have people in a room and see body language and read signals that don’t come through a screen, says the CEO.”

The irony? OpenExchange is a “Boston-based video technology firm which helps run large, online conferencing events.” If a tech firm that build products for remote work is struggling with it, and a company like Facebook (where most employees sit in front of a screen all day) is leasing more office space in New York during the pandemic, maybe the office as we knew it a few months ago isn’t dead.

A rational counterargument to this thesis is that even if, say, 25% of employees work from home post-pandemic (compared with about 15% prior to it) there will need less demand for office space and rents for existing buildings will fall materially. Maybe this is why landlord stocks are down 40-50%. I think this view is overly simplistic.

An ever-expanding economy means that employee counts are almost always growing, which is why new office space is regularly built. Therefore, I would expect that any modest decline in office demand is going to show up first in reduced construction of new buildings, not the abandonment of existing ones.

Consider that maybe a company grows its employee base by 10% over the next 3 years but can get away with using the same office space it currently leases due to more remote work in the future. In that case, existing leases are still going to be renewed. Without a lot of vacancy, rents should be stable. In fact, if new construction really does drop meaningfully, it could actually put upward pressure on rents for existing space, a phenomenon we have seen a lot in recent years in the residential housing market, where in many markets fresh plots of land and skilled labor are in short supply.

The bottom line for me is that it is rare for premier commercial real estate in gateway cities across the country to be quoted on the public market for a deep discount and I think 2020 is one of those times. Fortunately, regular folks can get in on the action via the U.S. stock market rather than needing to buy up properties themselves, which is obviously not financially feasible in most cases.

Loose Merger Agreements Are Causing Corporate Clashes Among Partners

It is being reported that Sycamore Partners is trying to get out of their $525 million deal to acquire a controlling stake in Victoria’s Secret, claiming that the chain violated the agreement when they closed their stores due to the pandemic. I have not read that particular agreement, but I was curious whether there was a MAC (material adverse change) clause in Simon Property Group’s deal to buy Taubman Properties and extend their lead as the dominant shopping center REIT in the country.

The language in their merger agreement is likely similar to most that were drafted during a bull market (light on conditions that would allow the buyer to walk away). In fact, I was pretty surprised to see what events were listed specifically that would under no circumstance warrant exiting the deal. Form page 82 of the agreement:

That’s right. Why should a pandemic impact the closing of a merger between shopping mall giants? :)

I wonder if lawyers will leave pandemics on that list in future merger agreements or if Covid-19 really will come and go without leaving a trace longer term in the corporate world. Hopefully buyers will get smarter and protect themselves against long tail events.

Interestingly, TCO stock is currently trading around $41 per share (22% below the deal price of $52.50 in cash). As a Simon shareholder, I hope they are able to negotiate the price down but still use their vast liquidity to scoop up Taubman’s trophy assets. With the deal supposed to close around mid-year, we should find out soon enough.

As Markets Stabilize While Peak Infection Rates Loom, Where Should Fresh Capital Go?

My last post highlighted the fact that the U.S. stock market in recent times has tended to find a lot of support around 15x trailing earnings. It appears that equities have calmed down a little in recent days, with a bottom having been made (perhaps temporarily) on March 23rd. On an intra-day basis (2,192) the valuation at the bottom was 14.0x 2019 S&P 500 profits. On a daily closing basis (2,237) it comes to 14.2x and on a weekly closing basis (2,305) the figure is 14.7x.

I am not going to predict that we have seen the lows. Even the experts in the field are merely guessing as to Covid-19’s ultimate infection path and even scarier to me is that I doubt health and government officials even have a plan for a slow loosening of social distancing guidelines, so we really don’t know what to expect from a economic rebound perspective. On one hand, I am comforted that the market did find a bottom around similar levels to recent years’ corrections, but on the other hand this situation is so much different than prior instances that I am not sure it is a very strong comparable event.

So rather than try and guess these things, like so many pundits in the media insist on, I think it is more helpful to think about where fresh capital could be deployed on a long-term basis as we wait this whole thing out. I am finding it too early to average down on more controversial existing holdings (travel-related, for example) because companies have not given us much data yet. Most have disclosed cash balance and credit line availability, but without knowing cash burns rates that only tells us so much.

So then the attention turns to businesses that are publicly traded, beaten down, and are less reliant on credit availability even if they are shut down. Essentially, high quality businesses that are on sale now but typically are not. Sure, there are examples in sectors where headwinds abound (Starbucks down 35%, for example), but there are more obscure ideas too. How about the few publicly traded professional sports teams? How confident are we that sports franchise values will continue to rise over the next 5 years? Even if seasons are cancelled, will the franchises lose 25-35% of their value for a significant amount of time? How often can small investors buy into sports teams at a big discount? Not often.

I know rental income in the near-term is problematic, but seeing owners of hard assets like real estate down 50-70% in a month is startling (and likely an opportunity). And you don’t need to go out and buy mall owners if you don’t feel inclined. How about Ventas, one of the leading owners of medical facilities? The stock is down 65% since February.

How about the big banks that were forced to be well capitalized so they could weather something like this? Jamie Dimon just went back to work after emergency heart surgery and JP Morgan Chase is widely considered the best-run bank in the world. It’s stock is down 40% from its 52-week high.

There are many companies I feel like I need for information from before I can decide whether to cut them loose or buy more shares. There are others where I feel like I can get comfortable given the low price, no matter how the next few months shake out. If you find unique situations where the franchise value is likely very secure and yet the stock is still down far more than the market itself, take notice. You might be surprised what you find. I mean, honestly, should Target stock be down 30% in this environment?

Happy hunting!

Full Disclosure: Long shares of Starbucks at the time of writing, but positions may change at any time

As Plummeting Oil Prices Compound Economic Concerns, Here Are 2 Things To Do This Week

Two weeks ago we saw a severe stock market decline, which was followed up with whipsaw volatility but a leveling off of prices overall last week. We are starting this week off with what appears to be somewhat of a panic by short-term market participants, with stock trading halted within minutes of opening Monday morning after a 7% drop (due to a exchange-imposed “circuit breaker” 15-minute trading halt - a rule in place, but never triggered, since 2013). As if the virus was not enough, now we have collapsing oil prices threatening the viability of an entire sector of the economy.

If this week is the first time during the coronavirus scare that stock prices meaningfully diverge from the underlying businesses they comprise (a 2,000 point drop in the Dow in a matter of minutes can do that), I would offer two actions investors should consider:

1) Don’t sell stocks simply to try and relieve the pain and prevent further paper losses in the near-term

While it is never reassuring to see stock prices diverge from corporate fundamentals and traditional company valuation metrics, selling securities when prices are irrational rarely pays off. In order for that bet to work, you need to be able to buy back the stock at lower prices (i.e. at even more irrational prices) in the future.

Not only is such a task extremely difficult when it is one’s main objective, but the very fact that somebody wanted to sell during a period of intense pain probably greatly reduces the odds the same investor would be able to buy back those shares after that pain has intensified.

The two smartest options during periods of near-term market dislocation/panic are to either buy mispriced securities with the intention of holding them for (at least) a year or two if needed, or wait things out until normalcy returns and any transaction you want to consider can be consummated at a fair price.

2) Strongly consider refinancing your mortgage

Mortgage rates have now hit all-time record lows, with the average 30-year fixed rate pushing towards 3.00%. I recommend getting a quote from your mortgage broker to see if the monthly savings from refinancing now is meaningful for you. To get judge the return on investment, I always try to see what mortgage rate I can get that offers a lender credit roughly equal to the closing costs. That way, the deal not only costs you close to nothing out of pocket (excluding the funding of an escrow account, if required by the lender), but also maximizes the ROI on the transaction.

Reevaluating the Bullish Investment Thesis on The Howard Hughes Corporation

When the Howard Hughes Corporation (HHC) was spun off from General Growth Properties during its bankruptcy process in late 2010 it was an underfollowed, relatively unknown collection of unrelated real estate assets mostly located within a few master planned communities in Hawaii, Maryland, Nevada, and Texas. The communities were vibrant residential and commercial hubs in their respective local markets and HHC owned thousands of acres of vacant land that would allow for decades of future development, either by the company itself or by third parties who would buy the land or partner with HHC.

The investment thesis was very compelling for long-term investors willing to wait 5, 10, or even 20 years; HHC will sell vacant land to homebuilders and use the proceeds to build and lease office buildings, retail shopping centers with ample restaurants, multi-family residential buildings, hotels, etc. to make the area even more desirable. The population growth would lead to ever-increasing land prices and the process could be repeated until there was no land left to build on, creating plenty of value for shareholders.

The key aspect that set HHC apart from other real estate developers was that they owned the vacant land already, enough for 2 or 3 decades of construction activity, which meant they could fund commercial construction projects with cash generated from land sales, not by borrowing from banks and racking up debt like most of their peers. That strategy would allow for less leverage and more value would accrete to equity holders rather than creditors.

The success of HHC stock in the eyes of their investors over the last decade varies greatly depending on when each of us got in (as one should expect). Most of my clients have made money in the name, but I also bought some when sentiment was high and it was fully priced in the near-term (the idea was that for a such a long-term investment, the entry point was a little less important than in other situations) and those blocks are flattish at best and slightly down at worst.

The exact buy price probably would have been relatively unimportant had the thesis played out exactly as expected. But, that has not been the case. Now I am left with a stock that is up nicely from its 52-week lows and remains included in many accounts I manage (as well as my personal portfolio). The question is, should we sell or keep holding it?

First, let me share some data to illustrate why HHC has not been the very unique public real estate developer many had hoped for since 2010. The bull thesis (that HHC would handsomely outperform other similar public real estate stocks) hinged largely on the idea that debt financing needs would be reduced due to a constant stream of cash coming in from vacant land sales. On the face of it, this looks like it should have played out, as HHC has booked cumulative land and condo sales of $4.32 billion from 2011 through September of 2019. Gross profit on those sales comes to a whopping $1.85 billion.

Flush with cash, HHC did what it said it would do; build a heck of a lot of leasable commercial real estate and own the properties long term to generate a consistent stream of rental income (that Wall Street would theoretically love). Sure enough, HHC's rental income had risen from $95 million in 2010 to $396 million by 2018.

If HHC had simply reinvested the $1.85 billion and generated an incremental $300 million of annual rental income (worth about $3 billion of equity value at a 10x multiple on gross revenue), the total return for shareholders on that investment would have been 62% and proven out the bullish thesis in a powerful way.

So far so good, right? Maybe, but there is one problem; debt at HHC has soared right alongside land sales, construction activity, and rental income. Rather than build properties with minimal debt financing, setting themselves apart from their peers, HHC has funded their construction costs via traditional methods. At the end of 2010, total net debt on the books was merely $34 million ($285 million of cash against debt of $319 million). As of year-end 2018, that figure had swelled to a stunning $2.68 billion ($500 million of cash against $3.18 billion of debt).

If you realized what HHC was in the early days once it started trading, it was undervalued enough that none of the above mattered. The stock closed its first trading day in November 2010 at $38 and nearly doubled to $73 by year-end 2012. However, since then the ever-rising debt load has held back the stock, which closed out 2013 at $120 and has been treading water ever since (albeit in volatile fashion which has afforded investors trading opportunities along the way):

The company ran a strategic review process in the second half of last year that resulted in a stock price spike, allowing me to pare back and/or hedge most of my positions in HHC. There was a glimmer of hope after no buyers for the company emerged in that management announced it would sell non-core properties, focus on its main master planned communities, materially cut G&A costs, and use excess cash flow to repurchase stock that they felt was undervalued. That plan resonated with me and gave me hope that the debt pile would stop rising so fast and perhaps some equity-friendly moves were on the horizon.

That optimism was short-lived, however, with the December 30th announcement that HHC agreed to acquire from oil giant Occidental 2.7 million square feet of office space for $629 million, to be funded with $231 million of equity and $398 million of additional debt.

Bulls would argue that given their plans to sell part of the assets being acquired (a campus outside of the Woodlands), the remaining deal to buy 2 office towers within their most mature community is a good move. And considered by itself, perhaps they are right. My issue with it is that it represents more activity that does not set HHC apart (using internally generated cash flow to grow their commercial property portfolio). Having HHC borrow money to buy existing buildings at fair market prices is the playbook that every other real estate company is employing, which means the long-term unique investment thesis for the company remains elusive.

There have been other missteps too. The South Street Seaport in New York City was supposed to be a trophy asset for the company, as it held a long-term ground lease and planned to rebuild much of the area around Pier 17 as a premier destination for locals and tourists alike:

What management had originally thought would generated above-average returns quickly turned into a money pit. The original construction budget of nearly $500 million was supposed to generate double-digit returns, but delays and redesigns has seen the cost estimate surge past $700 million. Management is still maintaining the goal of the property eventually earning $40 million to $50 million annually (making it an average project, at best), but the Seaport is currently losing money and will take years to reach that goal, if it ever does.

To make matters worse, we learned last year that HHC has decided to move away from its typical business model (leasing space to tenants) and instead has co-invested in many of the Seaport businesses, even choosing to operate some themselves. They claim there is more upside potential by structuring deals as joint ventures, but they are supposed to be landlords collecting rent and leaving the risk for the business owners. Now they have business losses offsetting rental income, which will reduce returns on the project further.

The nail in the coffin for me was their $180 million purchase of a parking lot adjacent to the Seaport in mid 2018. As they began due diligence on erecting a building at the site, they discovered that the parking lot had once been the site of a thermometer factory and contained toxic levels of mercury, as well as petroleum leaks. Parents of student from a nearby school are freaking out at the prospect of a demolition project potentially exposing children to toxic chemicals, which is delaying HHC's timeline for hiring professionals to clean up the site. Count me as one who hoped HHC would find a buyer for the Seaport last year when they shopped the company's assets, but no such luck.

All in all, without a path forward that includes revenue growing materially faster than debt, I am not sure there is a unique story here for HHC investors anymore. Between December 2013 and September 2019, rental revenue has grown by 165% while gross debt has grown by 139% and net debt by 282%. It is hard not to think that is a major reason why the stock price has barely budged during that time. Unless and until the financial strategy changes, maybe HHC isn't all that special. While it seemed like the ultimate long-term buy and hold stock when I first discovered it back in 2011, today it might no longer warrant such praise.

Full Disclosure: At the time of writing, the author and some of his clients were long HHC, but those holdings are currently under review for possible sale and positions may change at any time.

Howard Hughes Corp: A Lesson in Price vs Value

I was planning on writing a bullish piece on real estate developer Howard Hughes Corp (HHC) today, as the stock has been crushed in recent months and closed yesterday at $92.59 per share, 35% below its 52-week high.

Well, that idea quickly went out the window when CNBC's David Faber reported shortly after the opening bell that HHC's board has hired Centerview Partners to explore strategic alternatives, including a possible sale, joint venture, or spin-off of all or parts of the business. To say that the stock is reacting positively to the news would be an understatement. As I type this HHC shares are up $29, or 31%, to $121 each.

So rather than explain why the stock appeared dramatically undervalued in the low 90's, which I was apparently one day too late in sharing, I will instead offer up the observation that Warren Buffett's often-quoted mantra "price is what you pay, value is what you get" is notable in this case.

Some investors give more credence to that concept than others, mainly because while value investors try to find situations where value > price, more short-term and/or technically-inclined investors use the market price as their guide and believe that the daily matching of buyers and sellers across the globe corrects most any material pricing inefficiency. Not surprisingly, I am in the former camp.

HHC is an interesting case because most fundamental analysts believe that the company's assets are worth between $130 and $170 per share, net of debt, and that those same assets should grow in value nicely over time given their strong locations within the local trade areas they serve. Of course, if this is true, and markets are quite efficient, then the stock should not have closed yesterday at $92 and change.

Typically, bulls and bears are left arguing back and forth about who is right, but sometimes we get a better sense through actual corporate action. We won't know whether HHC finds a buyer for some or all of its assets for at least several more months (and if so, at what price) but today's trading action seems quite odd.

I would say that it is rare that a stock surges more than 30% on news that the company has hired bankers to approach possible buyers because we are still very far away from getting any idea as to how many interested parties there are, or what prices they might be willing to pay. Stock moves like this are usually seen late in the process, when a journalist gets word of who is bidding and what the range of bids has (roughly) been. In this case, CNBC's Faber merely confirmed the hiring of advisors because the process has just begun.

What that tells me is that investors seem to believe a few things. First, that HHC's net asset value per share is, in fact, materially higher than yesterday's closing price. Two, that the market believes that there will be ample interest in HHC's assets such that bids are likely to materialize (though of course no deal can be assured). And three, it probably helps HHC that interest rates have recently come down and lending capacity from financial institutions, hedge funds, and private equity firms appears robust, though obviously that can change quickly in today's world.

I say all of this because I think it firmly supports the notion that markets in the short term can be quite inefficient. Up until today, HHC stock did not have many fans, but that changed in a matter of minutes as the fundamental story changed (or more precisely, a layer was added; the fact that the board is open to strategic alternatives). Conversely, if it was true that the market was efficient and the consensus view among HHC's close followers was that the business was worth somewhere close to Wednesday's closing price, we would not see the stock surging today.

The beauty, of course, is that now we might very well be able to settle the debate about HHC's net asset value (or at least the opinion of that NAV among folks who want to buy the assets and have the cash to do so). The next few months should be very interesting.

Full Disclosure: Long shares of HHC at the time of writing, though I have been trimming positions into today's strength, as Wednesday's announcement confirmed they are open to selling, whereas the stock is acting as if a deal is nearing completion.

*Author Update* 4:30pm ET

HHC stock leveled off for a while and then surged again late in the trading day, closing at $131.25, up nearly 42% for the session. In the spirit of full disclosure, I have continued to sell more at prices as high as $131.50 and have also written some $140 covered calls against shares that remain in client accounts.

Simply put, I understand HHC is a unique company with great properties and I have no doubt that some bidders will emerge to try and pull some of them away from HHC. That said, this one-day move is pretty remarkable and I think it is overdone in the short-term. Accordingly, I think it is silly to not sell any stock at these levels, and would welcome a scenario where it cools down and I can buy back some of the sold shares at lower prices. Tomorrow (the last day of the quarter) should be the second-most intriguing trading day for HHC this year! :)

Lastly, some people are speculating that this announcement was all about juicing up Bill Ackman's portfolio right before the end of the quarter and nothing truly will come of it. While a deal might not happen, I don't think Bill's HHC position is big enough (just 2% of disclosed portfolio value as of 3/31/19) for him to have orchestrated this whole thing just to show a better performance figure for Q2. After all, Pershing Square was already having a great year and another 100 basis points is a small prize for such an effort. Just my two cents...

As Coastal Housing Markets Cool, 2017 IPO Redfin Is Worthy Of A Watchful Eye

For all of the business model evolutions and technology-led disruptions throughout the service economy in recent memory, the 6% realtor sales commission (a truly obscene amount for higher priced homes) for the most part has been unscathed. Tech upstarts like Redfin (RDFN) are trying to make a dent and are making progress, albeit slowly.

Public for less than 18 months after their IPO priced at $15, RDFN is using technology to save home buyers and sellers money. The company has been expanding its 1% sales commission structure rapidly, which can cut home sellers commission expense by 33% (4% vs 6%). Like Zillow (Z), RDFN also strives to offer customers ancillary services, such as mortgages.

RDFN stock had been trading pretty well, relative to the $15 issue price, up until recently:

The issue now is that RDFN was started in Seattle and focused initially on higher priced big cities for its lower sales commissions. The reason is pretty obvious; taking a 3% cut on a $200,000 home in Spokane is equivalent to taking a 1% cut on a $600,000 Seattle listing because each will take roughly the same labor hours. The idea that said Seattle seller would pay $36,000 to sell their house is a bit nutty, but that structure has largely survived in the industry.

Fortunately for RDFN, the coastal housing markets have been on fire, including double-digit annual gains in their home Seattle market for many years now. The result has been a strong revenue growth trend for the company, with 2018 revenue expected to top $475 million, versus just $125 million in 2014.

With those same markets now showing clear home price deceleration and inventory stockpiling, RDFN should see pressure on its near-term financial results, and likely similar headwinds for the publicly traded shares.

Long term, however, RDFN's future appears bright as it continues to expand its business across the country, taking aim at the traditional 6% sales commission structure. The company's market share reached 0.83% as of June 30th, up from 0.33% in 2014. While that figure is tiny, it shows you just how much business is out there for newer players to steal.

To be a long-term bull on RDFN, one needs to believe that over the next 10-15 years they can continue to grow market share and perhaps reach 5% penetration of a market worth tens of billions per year. The good news is that the company has enough money to try and get there. After a recent convertible debt offering, RDFN has about $300 million of net cash on their balance sheet, compared with an equity value of roughly $1.65 billion. That cash is crucial, as the company is purposely losing money now to grow quickly (cash burn has been in the $20-$30 million per year range).

It is hard to know what a normalized margin structure for RDFN could look like, and therefore assigning a fair value is not easy. With nearly $500 million in revenue and $300 million of cash, the stock does not appear materially overpriced today if one thinks they can earn 15%-20% EBITDA margins over time and therefore trade for 1.5x-2.0x annual revenue.

That said, if coastal markets continue to cool over the next few quarters, RDFN could dial back financial projections for Q4 and 2019, which would likely put pressure on the stock short-term, despite it being a long-term story for most investors. Accordingly, I think RDFN is an interesting stock to watch, especially for folks looking for growth without having to pay a huge premium for it.

Even Great Investors Like Bruce Berkowitz Make Mistakes

I know, I know, the headline above is not earth-shattering news. Every quarter dozens of the world's best investors disclose their holdings to the world via SEC filings (granted, the data is about 45 days outdated, but it still gets lots of attention). It's easy for individual investors to follow well-known money managers into certain stocks, figuring that they can piggyback on their best ideas. I can certainly find far worse investment strategies for people to implement, but it is still important to understand that even the best investors make mistakes. And there is nothing stopping the stocks you follow certain people into from being one of the mistakes rather than one of the home runs.

I think this topic fits right in with my previous post on Sears. Not only is Eddie Lampert the company's CEO and largest shareholder, but he is one of the best hedge fund managers of the last 25 years. It is perfectly reasonable to assume that a billionaire in his position would be primed to create tons of value for investors. And yet, since Lampert orchestrated the merger of Kmart and Sears, which formed Sears Holdings in 2005, the stock price has dropped from $101 the day the deal was announced to $40 a decade later. Adjusted for dividends and spin-offs received over that time, Sears stock has fallen by about 40%, while the S&P 500 index has risen by about 80% during the same period. Eddie Lampert's ownership and involvement alone has meant little for investors' portfolios. Simply put, Sears Holdings has been one of his mistakes.

Interestingly, many of the company's steadfast bulls point to the fact that another very smart and successful investor, Bruce Berkowitz of Fairholme Capital Management, owns 23% of Sears Holdings. That's right, Lampert and Berkowitz own or control 70% of the company. Berkowitz isn't new to the Sears investor pool either; he started buying the stock in 2005 just months after Sears Holdings was created. How can both of these guys have been so wrong about Sears for so long? It's not a tricky question. Neither of them is perfect and they have made (and will continue to make) mistakes. It really is that simple. Since I have written about Eddie Lampert many times since this blog was launched ten years ago, I think it would be interesting to try and figure out why Bruce Berkowitz has been on the losing end of Sears.

Berkowitz's background is in analyzing financial services companies, which is why you will often find most of his capital allocated to banks and insurance companies. Those industries are his bread and butter. In fact, Berkowitz's flagship Fairholme Fund had more than 80% of its assets invested in just four companies as of February 28, 2014: AIG, Bank of America, Fannie Mae, and Freddie Mac. If that doesn't signal his preponderance for financial services companies, I don't know what would.

Now, Berkowitz has not been shy about why he invested in Sears Holdings; he thinks there is a ton of hidden value in its vast real estate portfolio. Unfortunately, his trading record in Sears (he first bought the stock during the third quarter of 2005 at prices well over $100 per share) shows that real estate might not be one of his areas of expertise. Warren Buffett has popularized the term "circle of competence" and tries very much to only invest in companies he understands very well. That's why up until recently (his 2011-2013 purchases of IBM shares bucked the trend) Buffett has avoided technology stocks.

I would postulate that real estate investments do not fit squarely into Bruce Berkowitz's circle of competence. As you will see below, his trading record in Sears underscores this, but we have also seen it with his massive and long-standing investment in St Joe (JOE), a Florida real estate developer.

Below is a quarterly summary of Fairholme Capital Management's historical trading in Sears stock (I compiled the data via SEC filings). Of the 24.5 million shares Fairholme currently owns, more than 55% (13.6 million) were purchased over a 15-month period between July 2007 and September 2008, at prices averaging about $110 per share. More troubling is that this was when real estate prices in the U.S. were quite bubbly, coming off a string of record increases (most local markets peaked in 2006 and 2007) and Berkowitz was largely investing in the company for the real estate. The timing was quite poor. All in all, if we assume that Fairholme paid the average price each quarter for Sears, the firm's cost basis is about $85 per share (before accounting for spin-offs).

St Joe (JOE) has also turned out to be one of his relatively few mistakes. It could certainly be merely coincidence that both the Sears and St Joe investments were made based on perceived (but yet-to-be-realized) real estate value, but I'm not so sure. Like with Sears, Fairholme Capital Management has a very large stake in St Joe. In fact, Fairholme is the largest shareholder (owning about 27% of the company) and Bruce Berkowitz is Chairman of the Board (sound familiar?). Berkowitz started buying St Joe during the fourth quarter of 2007, around the same time he was massively increasing his investment in Sears. His largest quarterly purchase was during the first quarter of 2008 (talk about bad timing), when he purchased more than 9.2 million shares (37% of his current investment).

St Joe's average trading price during that quarter was about $38 per share, but subsequent purchases have been at lower prices, so the losses here are not as severe as with Sears. By my calculations (see chart below), Fairholme's average cost is around $28 per share, versus the current price of about $20 each. But again, not only has the investment lost about 30% of its value, but the S&P 500 has soared during that time, so the gap in performance is so wide that it would take a small miracle for either of these investments to outpace the S&P 500 index over the entire holding period, as the returns needed to make up for 7-10 years of severe losses during a rising stock market are significant.

Now, the purpose of these posts is not to point out the few big mistakes two very smart investors have made over the last decade, while failing to mention their big winners. Any of my readers can look at the history of the Fairholme Fund or ESL Partners (Eddie Lampert's hedge fund) and see that they both have posted fabulous returns over many years. The point is simply to show that sometimes these investors make mistakes, even with companies where they own and/or control a huge amount of the stock. Just because Eddie Lampert and Bruce Berkowitz are involved in a major way (either in ownership, operationally, or both), it does not ensure that the investment will work out great for those who eagerly follow them. Just because they are smart investors does not mean these are "can't miss" situations. There are plenty of people who are sticking with Sears because of Eddie, or sticking with St Joe because of Bruce. That alone, however, is not necessarily a good reason to invest in something.

I will leave you with one more example of Bruce Berkowitz making a large bet on a stock outside of his core financial services wheelhouse. At the end of the third quarter of 2008 Fairholme Capital Management owned a stunning 93 million shares of pharmaceutical giant Pfizer (PFE). It was an enormous position for him and was featured in many investment magazines. This single $1.73 billion investment represented as much as 24% of end-of-quarter total assets under management for Fairholme, and all of those shares were purchased over a 26-week period in 2008 (more than 3.5 million shares purchased, on average, every week for six months).

Now, given how large of a bet this was, even by Bruce Berkowitz standards, it would have been easy to assume that this investment would be a home run. But as you can see from the trading data above, Fairholme lost money on Pfizer after holding the stock for only about 18 months. During the fourth quarter of 2009 alone, the firm sold more than 73.4 million shares of Pfizer (after having purchased 73.7 million shares during the second quarter of 2008). Perhaps pharmaceuticals aren't Bruce Berkowitz's bread and butter either. Fortunately for him and his investors, however, his prowess picking banks and insurance companies has helped him compile an excellent track record since he founded his firm in 1997.

Full Disclosure: No position in St Joe or Pfizer at the time of writing, but positions may change at any time.

If Your Mortgage Rate Is Meaningfully Above 4.3%, Consider Refinancing Now

Lots of hedge funds are having a very difficult start to 2014. Many were short long-term bonds as a hedge against a correction in U.S. stocks. Despite profit-taking in equities this month, bond prices are surging and yields are falling. The benchmark 10-year treasury bond has seen its yield drop from 3.03% on January 1st to 2.65% today. Mortgage rates have followed suit, dropping to 4.31% (30-year fixed) according to bankrate.com. A 15-year mortgage now costs about 3.35%, nearly a full point lower.

If you have a mortgage with a rate significantly higher (say, 5% or above), I would recommend crunching some numbers to see if refinancing would make sense. I don't expect rates will stay below 4.5% for very long so this pay be one of the last chances to lock in a great rate. Also, people tend to ignore the 15-year mortgage option (the payment is typically about 50% higher than a 30-year mortgage, despite a lower interest rate), but it could very well be an attractive option for some people, especially if your current payment does not make up a large portion of your discretionary income.

For instance, let's say you currently have 20 years and $200,000 remaining on a 30-year mortgage at 5% (monthly payment of ~$1,075). If you could handle a payment of ~$1,425 you could refinance into a 15-year mortgage at 3.5% and have your house paid off 5 years early. The increased cost might not be workable for many, but for those looking to cut monthly expenses or retire as soon as possible, a refinance might aid in the process.

Single Family Rental REITs May Have More Potential Than Wall Street Believes

Tom Barrack, the founder of real estate giant Colony Capital LLC, recently appeared on CNBC and made some interesting comments about the single family rental market that I think are worth considering from an investment standpoint. Colony Capital is one of the big private equity firms, along with Blackstone (BX), that has been an active buyer of single family homes, which it intends to spruce up and rent out.

At first glance you might think that the single family rental market would be a solid business model, provided you have experienced people making the operational decisions and savvy financial people ensuring an adequate return on capital can be realized. However, much has been made in the financial media about how the likes of Colony and Blackstone have caused sudden and dramatic price increases in the markets they have entered (mostly those that saw housing prices fall the most, and therefore presented great entry points for those firms who had the capital to buy foreclosed homes). In markets like Las Vegas and Phoenix, price increases have been stunning, with 25-30% one-year increases not uncommon.

There are two ways of looking at these developments. The bearish case is that private equity investors have bid up prices of these homes too much, and the returns they will ultimately achieve from renting them out will be unimpressive. This view seems to be winning the day right now, as several single family rental real estate investment trusts have gone public recently [Silver Bay Realty (SBY) and American Homes 4 Rent (AMH) to name a couple], and they are mostly trading around or even below book value per share. Typically companies that earn a decent return on equity trade at a premium to book value, so investors clearly doubt the viability of the business model right now.

Mr. Barrack, on the other hand, offered a more bullish view on the sector during his CNBC appearance. Now, you can say that since his firm has purchased tens of thousands of single family rental properties, he is simply talking his own book. But given Colony Capital's track record, I don't think Tom Barrack's opinion is something investors should simply dismiss. Besides, he really has little to gain at this point in his career from disingenuously talking up the single family rental market. Ultimately, the renters will determine how well his firm's investment performs.

Barrack believes the single family rental market will provide attractive investment returns, provided companies due their homework and don't overpay for their properties. Given how far home prices fell peak-to-trough in the markets where private equity investors have focused, the mere fact that their buying activity has pushed up prices does not ensure that future returns on rentals will be sub-par. It is widely believed that many areas of the country saw home prices reach absurdly low levels (below replacement cost by a wide margin), so it is entirely possible (and I would argue likely) that private equity involvement has merely accelerated the timetable for when these homes returned to a more realistic market value. And assuming rental market demand remains solid, there is likely plenty of money to be made.

On that end, Barrack pointed out that there is a wide disconnect between the valuations of the single family rental REITs (again, at or below book value in many cases) and the large apartment rental REITs like AvalonBay Communities (AVB) and Equity Residential (EQR), which both trade at 1.8 times book value. In his view, the single family rental companies will be able to prove they can earn solid returns over time, and as a result, he believes their stocks will trade closer to the valuation levels of apartment REITs. If that is the case, there is quite a bit of potential in the single family rental market, not just for the private equity firms themselves, but for smaller investors as well who want to play the trend via the stock market.

This investment thesis makes a lot of sense to me, although I admit I have just started digging into these relatively new single family rental companies (my research is hardly complete at this point). That said, it''s hard for me to articulate why the underlying business fundamentals and return characteristics of these two markets would be materially different from one another. After all, is there really a big difference between buying a 50-unit apartment building and buying 50 single family homes and renting those out? Other than slightly higher costs associated with managing 50 separate properties instead of a single, larger one, it seems to me that the business models are very similar and could very well yield similar results.

Full Disclosure: No positions in any of the companies mentioned, but positions may change at any time