Defence, discipline and downside mitigation

The core investor’s playbook – by Chris Urwin

 
Who would want to invest in an opportunity that was more likely to fail than succeed? In most fields of investing, including real estate, the answer is nobody. But for venture capitalists, it is a different story.

“We are in the business of being embarrassed,” says Jim Goetz of Sequoia, one of the most distinguished venture capital firms.

In their field, most investments are unlikely to succeed. But those who do are likely to be big winners, or rather, extremely big winners.

As Bill Gurley of Benchmark has said, “Venture capital is not even a home-run business. It’s a grand-slam business.” It is the very rare, but very high-scoring moments that count.

Returns in venture capital follow a power-law distribution, with the majority of returns concentrated in a small percentage of companies. This means the challenge for venture capitalists is to be ambitious enough, according to Sebastian Mallaby, who has written a history of venture capitalism called The Power Law.

Invest too timidly and you will be backing ideas that others can imitate, limiting long-term profitability. It is the job of a venture capitalist is “to look over the horizon, to reach for high-risk, huge-reward possibilities that most people believe to be unreachable,” says Mallaby.

To back such ambitious and high-risk ventures, investors need to be willing to risk failure. This might not come naturally to many people. The best operators have thoughtfully designed their investment processes to overcome loss aversion.

At Sequoia, for example, partners presenting an opportunity include in their investment memo a description of the company’s growth assuming everything goes perfectly. “We need to be comfortable to say out loud what might be possible,” says Jim Goetz. The investment process needs to be explicitly focused on the upside. Combined with intelligent thinking about position sizing, this has proven to be a successful formula.

The key lesson for those in real estate is that successful investing requires careful consideration of the appropriate risk appetite and the deliberate calibration of mindsets and investment processes.

Many real estate investment managers start operating to serve a certain risk appetite. As they mature, they seek to broaden their offer. Lots start in the value-add or opportunistic space, and then seek to grow into core or core-plus investing.

Such transitions can be highly successful. But to have the best chance of success, organisations need to recognise that they are playing a different game and learn to operate with a new playbook. Investment processes need to be reconfigured and mindsets changed.

All real estate investors need the majority of the assets in their portfolio to perform. But as with venture capitalists, experience teaches opportunistic investors that fortune favours the bold. After all, if you back enough winners, you can tolerate a few losers.

That is not true, however, when investing in core real estate. Those moving into the space would be well advised to read Charles Ellis’s 1975 essay, The Loser’s Game.

Ellis draws lessons from tennis. He argues tennis is not one game but two. Professionals and experts play a winner’s game. These players are lucky enough to have the skill and ability to avoid mistakes and play winning shots.

Amateurs, however, play a loser’s game. The outcome of the game is typically determined by who makes the fewest errors rather than the most winning shots.

For amateurs, “…the strategy for winning is to avoid mistakes. The way to avoid mistakes is to be conservative and keep the ball in play, letting the other fellow have plenty of room in which to blunder his way to defeat.”
 

“Investors should understand that they are playing a loser’s game, play defensively and avoid mistakes”

 
Ellis argues that by 1975, the average skill level among investors had increased to such a level that it was very hard to outperform the market. Big wins over other market participants were no longer possible. Investors should understand that they are playing a loser’s game, play defensively and avoid mistakes.

It is critical to understand that core real estate investing is a loser’s game. Core assets offer less exposure to upside risk. If you make a poor investment, you may struggle to recover your losses. So mistake prevention is the aim of the game.
 

“Acknowledge your limitations, remembering the proverb that it is the strong swimmers who drown”

Fortunately, “avoiding stupidity is much easier than emulating brilliance”, as Ben Carlson has written. But it does require discipline. Discipline to only play the shots you know you can play well, to stay in your circle of competence and to have the humility to acknowledge your limitations, remembering the proverb that it is the strong swimmers who drown.

More specifically, core real estate investors need to implement a robust investment process that promotes objectivity and tests what could go wrong with a proposed acquisition from every angle. They need a thorough understanding of the risk characteristics of the markets they are investing in and the potential dispersion of potential future returns. Furthermore, the behavioural biases that can so easily influence decision-making must be mitigated.An intelligently designed process for making hold-sell decisions helps too.

Playing defence in this way can be a route to remarkable success. It has certainly worked for some most distinguished investors.

Charlie Munger, for example, has said, “It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”

Meanwhile, Warren Buffet has said, “It’s not necessary to do extraordinary things to get extraordinary results.”

For an illustration of that, consider the strong, long-run performance of the pension plan Howard Marks discussed in one of his early memos. In its 14-year history, it never had a year below the 47th percentile or above the 27th percentile. As a result, it was in the fourth percentile for the 14 years as a whole.

The lesson from Marks, then, is to be consistent through a disciplined approach that avoids exposure to the worst performers.

So, if you change the game you are playing, you are going to need a different playbook. While high-risk investors might reach for the sky, the focus for core real estate investors should be much more down to earth, with an emphasis on defence, discipline and downside mitigation.
 

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