Sunday, September 23, 2007 1 comments ++[ CLICK TO COMMENT ]++

Sam Zell Lecture at Wharton

Forbes has a lengthy article on Sam Zell's recent lecture at Wharton. It is a very good article and I recommend it to anyone interested in real estate investing or contrarian strategies. Sam Zell, the Gravedancer (cool nickname; he also looks like one :) ), is a contrarian-type investor who made his fortune by buying real estate investments. He has owned large amounts of real estate but isn't a developer (refer to one of the quotes below to see why he isn't).

I never heard of Sam Zell until I looked into the Tribune merger. I have a position in TRB (wish I had more money to invest in that) and expect the deal to close. I think contrarians may want to read some of the stuff Sam Zell has done because he is a textbook example of a successful contrarian.

I am going to be heavily quoting the article because I find a lot of useful information in Zell's words and thoughts. I have bolded concepts that I find insightful.

...the Chicago-based investor said current markets are spooked by problems with U.S. subprime lending. However, they still have capital to deploy, unlike during other real estate busts, when financing could not be arranged at any price.

"We're not really in a 'credit crunch.' I think we're in a 'confidence crunch,'" said Zell, funder of the Samuel Zell and Robert Lurie Real Estate Center at Wharton. "I would argue the excess liquidity that existed eight weeks ago still exists today. It has a different risk premium on it, but the actual amount of liquidity has not changed."

Zell's view is different from the mainstream and is somewhat similar to mine. Zell seems to think that there isn't a credit crunch. I have felt the same way since this whole thing started unfolding. If this is indeed the case, I believe that the Federal Reserve did not cut rates due to the credit problems, but did so due to some economic problems (that we don't know about but their private data indicates).

According to Zell, private equity firms awash with capital benefitted from "preposterous" leverage and offered premium prices to publicly held real estate firms. Zell said he considered that type of deal a "Godfather offer"--because no publicly held company could responsibly refuse it.

Zell predicted markets will soon stabilize, although they will become more risk averse and less leveraged than in recent years. "Today, you would never be able to replicate the Blackstone deal."

In my opinion all this private equity boom is due to cheap debt financing. I think the LBO private equity boom is pretty much over. The market has re-priced some of the risky debt and is unlikely to offer cheaper debt in the near future.

Zell did not discuss that deal [Tribune buyout] directly, but pointed out his reputation as a contrarian investor. He recalled the first time he saw the market turn. In the early 1970s, the real estate industry was infused with optimism and expanding rapidly. Zell did not think there would be enough demand to fill the real estate space under development, so he stopped doing new deals and structured a company to focus on distressed real estate. "Everybody else said, 'Sam, you don't understand.' I have heard that my entire career. Even when I buy newspapers in 2007, everybody says, 'If you didn't understand before, now you really don't understand.'"

It can't get more contrarian than buying newspapers today. I hope the Tribune deal closes for my sake (I'm betting on a takeover) but it's worth thinking about the the business of newspapers.

Sam Zell has crafted an amazing deal with the Tribune takeover. I don't recall the numbers but he is basically risking (only!) around $400 million for a potential return of $3+ billion. It's an amazing deal for Zell but he can still lose it all if the newspaper business can't be turned around.

John C. Dvorak often has "weird" off-the-wall views on things (he mostly writes about technology) but his latest column is excellent and parallels my views (BTW, I highly recommend this article to anyone interested in the newspaper area). My personal feeling, similar to Dvorak, is that small papers will dissapear while large ones with original content dominate. I expect more and more people to flock to papers like The New York Times, Washington Post, Wall Street Journal, and in Canada papers like The Toronto Star, The Globe & Mail, while the smaller rural papers simply die off. Sam Zell is going to have his work cut out. Papers like the Chicago Tribune and Los Angeles Times, among others, can do well but not so sure about other holdings. Real estate is largely cyclical so you can just buy and hold, but the newspaper declines seem to be some secular long-term downtrend.

"I would tell you whatever business I've been in--real estate, barges, rail cars--it's all about supply and demand."

The most important lesson from Sam Zell! I'm becoming more and more of a contrarian investor with a value tilt. I am starting to realize that supply & demand plays a huge role in this type of investing. In contrast to other types of investing, such as momentum investing or sector rotation, I think a contrarian that is value-oriented needs to nail the supply & demand proposition. I am seriously looking at Owens Corning (OC; OCWAZ) and supply & demand is something I think about a lot.

Following a market crash in 1973, Zell spent three years acquiring $3 billion in real estate assets, much of it for $1 down. He built his portfolio by approaching lenders and offering to take future operating losses off their hands in return for equity. Zell was able to carry the properties long enough for them to return to--and exceed--prior valuations.

You can see how Zell became a billionaire. Classic value investing... Buy something really cheap... Hold until it reaches more attractive valuation...

When Linneman asked Zell why he had never become a developer, the bearded, gravel-voiced mogul replied that development is too risky for his taste. "In that business, it helps to have an 'edifice complex,'" said Zell. "At least half of your rate of return comes from the psychological benefit you get from seeing the building go up. I never suffered from that particular affliction."

Zell never went into property development. For those of you interested in real estate and think property development is the only way to riches, Zell presents a case for doing it without development.

Zell and Lurie spent much of the 1980s diversifying their holdings into other businesses. Their strategy was the same as it had been in real estate--to look for opportunities in places where others were ignoring the rules of supply and demand.

The lesson to be learned: supply & demand...

While real estate professionals have excellent transactional skills, he added, they often lack the foresight to plot strategy. "When it comes to delegating the negotiation of a transaction, I would always pick a real estate guy over a corporate guy," said Zell. On the other hand, real estate people lack the ability to "look around the corner. To them, the tree is always growing to the sky. Therefore, we have enormous and very volatile cycles that continue to this day."

His thought about real estate professionals...

When it comes to real estate, Zell said he is focusing on development in emerging markets through a company called Equity Group International.

In 1999, Zell decided the REIT concept that had worked so well in the United States could be replicated in other parts of the world. He now controls major home builders in Mexico and Brazil, and is also branching out to India, China and Egypt.

He said the Guadalajara office of the Mexican company, Homex, is open 24 hours a day, seven days a week, to meet the needs of Mexican home buyers. "The beauty of all these places is there is unlimited demand," said Zell. "If you go back to Econ. 101, these countries have huge backlogs of housing demand. The population is increasing and housing has not."

Marc Faber is also bullish on real estate in developing countries. I have looked at real estate in emerging markets but I'm not sure how to invest there. They also look very risky right now given the huge run-up in almost everything in those countries (for example, real estate in some parts of India are ridiculous and worse than USA). If emerging markets correct--and I think they will if the US economy slows down--then foreign real estate will be a place to look. Real estate is probably a simpler bet in emerging markets than trying to invest in consumer goods, manufacturing, or technology, in those countries.

Zell acknowledged he does not always get it right. He told the story of how he acquired the Carter Hawley Hale stores in California in 1992...In 1995, he decided to bail out and sell the chain to its competitor, Federated Department Stores. The price? Even though he lost money on the deal, Zell finds comfort that his firm calculated the downside correctly... "The investment was a failure, but the process was a success. We identified the risk we were prepared to take, and we took it."

Good analytics can mitigate risk even when things turn against you. Too bad that such analysis is very difficult for newbie investors like myself.

"He who dances closest to the graves, always has to be careful he doesn't fall in."

A wise quote to add to the dangers of contrarian investing. The problem for newbie investors like myself is that I'm not sure how to mitigate the downside risk. A lot of contrarian opportunties have massive downside (basically bankruptcy or some such disastrous outcome) so I'm always scared.

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1 Response to Sam Zell Lecture at Wharton

February 10, 2008 at 2:52 PM

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