2019 Position Review
December 30, 2019
Exiting Stage Left…
January 27, 2020

The Only Constant Is Change…

Quick housekeeping note: I’ll be in Orlando for ICR from January 12 to 15. If you’re attending and would like to chat stocks, please email me at kuppy@adventuresincapitalism.com

Last week, I was in Coimbra, Portugal. For a bit over a century starting in 1131, Coimbra was the capital of Portugal. Looking at a map, it should be obvious why this was. Coimbra is situated on the north bank of the Mondego river, making it ideal both for defense from the Moors to the south and for river transport. At the same time, its central position made it ideal for managing the Reconquista, while keeping tabs on the Spanish to the east.

Then came “disruption.” Why isn’t Coimbra the capital of Portugal today? That’s obvious—kings want to be near where the action is. When the age of exploration started, the kings of Portugal moved to the key port city of Lisbon. Was there anything wrong with Coimbra? Of course, not. Coimbra still remains a center for education and study. The country’s leadership simply followed the money.

University in Coimbra

Famous library in Coimbra with bats that have protected it from bugs trying to eat historic manuscripts for centuries.

What happened to those property investors who bought the great Coimbra bull market of the mid-13th century? I’m sure they did fine, but the upside they expected wasn’t there. Instead, the country’s focus moved to Lisbon and the upside fizzled out in Coimbra. Why do I bring this all up? Because lots of people are paying low single-digit cap rates to acquire assets in gateway cities. Why do people pay 2% cap rates for these assets? I literally don’t know. Maybe they think rents increase on renewal? Maybe they think valuations increase and let them refinance? Maybe they hope to sell to some other property speculator who’s even more out of touch? It’s not like cap rates can go much lower. In the end, we can debate why forever. It simply makes no sense.

If you buy a property at a 2% cap rate, you’re effectively saying that it will take 50 years for you to recoup your capital outside of appreciation or financial engineering. Obviously, 50 years is a damn long time to wait. Do you know what the world looks like in 50 years? I sure don’t. What about a property in a random city on this globe?  Coimbra went from capital of Portugal to a backwater. Along the way, Portugal suffered through revolution, civil war, invasion, coup, change of government and all sorts of other political crises that forced property ownership changes. If your property gets expropriated in year 40, you’ve actually lost money despite tying up capital for four decades. Think about that for a second.

Now you may say, Kuppy, that’s Portugal. They do things a bit differently there. Here in America, assets are safe. Yet in America, we had a Civil War where most productive property assets in 11 states were either destroyed or reallocated. We’ve had rent controls—effectively redistributing the economics of property assets along with myriad other zoning and tax changes. The center of gravity has repeatedly shifted in America as well. 40 years ago, Miami was a violent backwater—now it’s a gateway market. Meanwhile, Baltimore was once a place that people actually wanted to live in.

I bring this all up because I remain mesmerized by current insane asset valuations. Property assets may at least theoretically protect you from inflation (I’ll disagree in a future post)—most equities don’t even have that advantage. When costs go up and revenues are fixed, margins get squeezed. Add some debt on top and it may be lights out.

Cheap debt may make people believe crazy things about asset values, but the history of interest rates says that we’re closer to the lower threshold on yields than the upper one. Will interest rates go up? Of course, they will—inflation is coming. Central banks may try and suppress rates, but they’ll lose control eventually—thousands of years of history says that they ALWAYS do. Look at what’s happening in the repo market, it’s actually starting.

I don’t intend to keep pushing my view on inflation and interest rates. I already said my part. Rather, as we enter a new decade, I thought it was important to remind investors that the only constant in the world is instability. Nothing is predictable—especially in business. Sometimes “risk-free” assets are actually the riskiest.

If you own 2% cap rate assets in gateway cities, you’d better be sure that interest rates stay suppressed forever as rental increases won’t matter when cap rates go from 2 to 8. Furthermore, you’d better check your portfolio for obsolescence. Retail has been “disrupted” already. Is office next? Even prosaic markets like agriculture are in for dramatic changes in the next few decades. Are you ready?

Lisbon and Porto get all the attention from tourists. That’s a mistake. The smaller cities of Portugal (like Coimbra) are absolutely charming and full of history. If you go to Portugal, make sure to rent a car and explore. You will be surprised at what you find…

If you’re paying top dollar for “compounders,” you’d better be damn sure that they’ll eventually grow into their valuations. 20 times revenue is a lot to pay when the product may not even exist in a few years. How confident are you in cash flows and asset values? As we start a new decade, just remember that smart guys were buying Coimbra a century after it became the capital—they got it wrong. Things can change fast—no one saw the age of exploration starting. Given how unpredictable things are, you’d better make sure you have a healthy margin of safety because tomorrow’s news may change your whole investment thesis. No business is permanent—but there’s a right price for everything. It’s a new decade, might as well double check on what you own. Are you ready for the change that’s surely coming? Remember, nothing is permanent…

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