How property and stock market investors can apply the same investment principles

Property investing and stock market investing are more similar than most people realise.

Of course, there are many differences in the details, but long-term investors who are active in either asset class can benefit from the same sound and timeless investment principles.

Ben Graham laid out many of these principles almost 80 years ago, but more recently I found them within the pages of “The Five Fundamental Principles of Property Investment”, written by Nick Carlile of Platinum Portfolio Builder.

Investment principle #1 – Always buy at a discount

The first investment principle is to always buy low, everybody knows that; but many, or perhaps most, fail to apply that knowledge.

The idea in property, according to Nick, is to always buy at Below Surveyed Value (BSV). Specifically, a discount of 25% to the valuation from a chartered surveyor is suggested as the most that should ever be paid.

Buying low increases the cash yield in the short term and also increases likely capital gains over the longer term.

As a value investor buying at a discount to BSV sounds virtually identical to Ben Graham’s idea of always buying with a healthy discount, or margin of safety, to intrinsic value.

Ben Graham suggested buying at a 33% discount, but whether the discount is 25% or 33% the principle of buying at a discounted price remains the same.

Of course, in the stock market, we don’t have chartered surveyors valuing companies. Instead, we have professional equity analysts who have, I would suggest, an almost infinitely more difficult job than a chartered surveyor due to the inherent uncertainty that surrounds the intrinsic value of almost all companies.

In most cases, the future of a company is far more uncertain than the future of a house, so coming up with an intrinsic value is far more difficult.

Professional equity analysts do not have a great track record, and so their “target prices” may not be a good basis for deciding on the intrinsic value of a company.

The efficient market view of intrinsic value is that it is equal to the current share price. The problem with that approach is that it’s impossible to buy at a 25% discount to the current share price.

My approach to buying companies at a discount is to buy them when their share price is significantly lower, relative to earnings and dividends than comparable companies with similar track records in terms of their growth and consistency over a period of many years.

Although there is no direct calculation of “intrinsic value”, this approach results in a portfolio of companies where valuations are lower and yields are higher than their peers.

Investment principle #2 – Always add value

In the world of property, the investor has direct access to the asset, i.e. the house, and therefore has the ability to improve that asset. In most cases, this means a new bathroom and a new kitchen, and that’s exactly what I did the last time I sold a house.

Stock market investors cannot improve the underlying asset, i.e. the company, in the same way. However, that’s not strictly true.

As a shareholder you have the right to attend the company’s annual general meeting, to (try to) ask questions of the board and to vote on various resolutions on board elections, pay and many other things.

However, this is not easy and most stock market investments are held in nominee accounts where the investor’s rights are effectively nil.

If you really did want to influence the company that you own then there are a few places that you could look to for more information, for example:

• ShareSoc – The UK Individual Shareholders Society, which actively campaigns for shareholder activism and rights, has a new campaign for shareholder rights being launched in October, with FT writers John Lee and John Kay speaking.
• ShareAction – The Movement for Responsible Investment, to whom you can lend your votes in an attempt to influence companies directly.

Investment principle #3 – Ensure that the investment is cash flow positive

A cash income is the defining feature of a financial investment. Unlike gold or classic cars (unless you hire them out), stocks, bonds and property pay an income.

For property investors, having cash flow-positive investments is more difficult than it sounds.

Of course, it’s easy to have a cash income from a house; you just stick a tenant into it, but property investments make more sense when leverage is used in the form of a mortgage. The problem is that while leverage can boost returns enormously, it can also turn a cash flow-positive property into one that sucks money out of your pocket rather than putting it in.

Mortgage payments have to be paid by the investor every month, but tenants sometimes don’t pay or they leave and cannot be replaced quickly enough. The result is that you have to feed more money into the investment, and it can be substantially more (unless you have insurance, which is yet another expense).

By buying at a discount to surveyed value and avoiding excessive leverage, perhaps putting down a 25% deposit, it’s much more likely that an investment property will remain cash flow positive throughout its lifetime.

In the stock market, this situation is usually more simple.

You buy shares in a dividend-paying company, preferably one that has a long and consistent dividend record, and you then pocket that dividend twice a year for as long as you hold the shares.

Overall, dividend-paying shares are almost always cash flow positive.

Sometimes the dividend may be cut, but the remaining dividend that is paid out is still a positive outflow of cash into your pocket. Even if the dividend is suspended the cash flow is zero rather than negative. And if you’ve invested in the right sort of company then it’s unlikely that the dividend will be gone forever.

Investment principle #4 – Always invest for the medium to long-term

If there is one difference between property investing and stock market investing that has the biggest impact on investor returns, it’s this one.

Buy and large property investors stick to this principle. They realise that over the long-run wages go up, which means that rents go up, which means that property prices go up as well.

Although there may be ups and downs as the economy goes through booms and busts and interest rates go up and down like a yo-yo, it remains true that over decades a property portfolio is almost certain to go up in value, and sometimes considerably so.

The same story applies to the stock market.

As total wages go up (either through population growth, inflation or real wage growth) then the total value of goods and services consumed goes up. This increases company profits, which allows increased dividend payments, which eventually leads to higher share prices.

Although there may be ups and downs as each company and the economy goes through booms and busts, in the long run, a portfolio of shares is almost certain to go up in value, and sometimes considerably so.

However, despite these similarities, most active stock market investors find it almost impossible to think in terms of years and decades rather than days, weeks and months.

Why is this the case?

It’s because property investors have virtually no information on the value of their properties from one day or one year to the next, and even if they did, it takes quite a bit of work and effort to sell a house.  Given these barriers to active trading, most property investors, and especially those in a scheme like Nick’s, just sit back and get on with their lives.

Stock market investors on the other hand are told, almost every second of every day, precisely what their investments are “worth” at this exact moment.

Then they’re told, by the media or other investors, that company X is down 20%, is likely to issue a profits warning, and is basically rubbish and hated by everybody in The City.

The final straw, which breaks the back of the sensible investing camel, is that having been pumped with fear by the news that they’ve “lost” 20% of their capital and that everybody knows the company is “doomed”, investors have the ability, at the click of the button, to sell those “losing” shares and replace them with the warm comfort blanket and certainty of cash.

That is basically why stock market investors are prone to selling low by selling what has gone down, buying high by buying what has gone down, and buying and selling too often (racking up trading expenses in the process) by paying attention to the “wall of noise” which makes up much of the investment media.

If only stock market investors would realise that the share price represents someone else’s opinion on what those shares are worth and, like all opinions and much of the wall of noise, it can be ignored.

A far saner approach in my opinion is to think of the stock market as precisely that; a market. You go to the market, you buy some quality goods (perhaps a bit of Sainsbury, some Marks & Spencer or Unilever), hopefully at a good price, and then go back home.

What other market traders subsequently think about the value of those goods is irrelevant.

What is relevant to the long-term investor is the positive cash flows that those companies produce, i.e. their dividends, and how those cash flows are likely to grow, or not, over the next decade or two.

As Nick says in his guide to property investing, “To be a true property investor you have to play the long game. Property is not a get rich quick scheme – it’s a get very rich steadily scheme”. Replace “property” with “stock market” and you’ll get the gist.

Investment principle #5 – Stack the odds in your favour

With this principle Nick talks about buying the right sort of property, one that is safe, solid and reliable, likely to always provide a positive cash flow by being attractive to tenants, and one that will require little additional capital invested by avoiding structural problems with the building and avoiding problem tenants.

Again that sounds very much like sensible stock market investing to me.

Of course, all companies, even the most defensive, are more risky than housing, but it is more than possible to buy a basket of defensive companies that are relatively safe, solid and reliable, and likely to always pay a dividend by being attractive to their customers and clients.

It’s also possible to find companies that require little additional capital investment, either by you via an unwelcome rights issue or through the company having to reinvest your profits in order to constantly replace expensive heavy equipment.

Sound investment principles apply universally

I know this idea, that stock market investing and property investing are really quite similar, can be a hard sell.

Believe me, I’ve spoken to a lot of people about housing and the stock market and 90% of them “get” property investing while 90% of them think that buying shares in the stock market is just too risky.

The truth is that they don’t have to be chalk and cheese.

They can both be thought of as sensible investments in income-producing assets which are very likely, over many years, to grow both their incomes and their capital values at rates that leave inflation in the dust.