Mar

23

 Given the current mortgage rates and the fall of the housing market, I want to purchase my first home. Since I am stationed at Fort Hood in Texas, I have been doing heavy research in the Killeen / Harker Heights area. I thought I would ask for some advice. I spoke with Tim Melvin about this earlier, and he mentioned that I should never pay more than 10 times the annual rental rate of comparable houses. Does anyone else have any other good valuation metrics like this or have any knowledge / advice that would help me out as a first time homebuyer?

Legacy Daily replies:

I have found 10x to be used in two cases:

1. High house prices relative to rent — get one to cool off and think more clearly about an investment and do additional homework 2. Low house prices relative to rent - get one to jump in without thinking clearly on a "bargain" investment without doing any additional homework 

Some initial questions worth clarifying:

1. Is this a home or a leveraged investment? a. home — ignore rules like this and find the best place to live, raise a family, pursue happiness… b. leveraged investment — do enough homework to be confident enough about the decision to ignore all general rules.

Assuming investment:

2. What is the holding horizon? What future plans could interfere with that holding horizon? 3. What is the appreciation potential for the country, state, county, city, town, neighborhood, subdivision, this property…? I have not yet been able to come up with sufficient justification to buy for income alone when it comes to residential real estate. 4. What segment of rental market would the property (subdivision, neighborhood, town, etc.) attract? Is that the segment one wants to serve? Real estate agent needed to rent? 5. How predictable is the income stream? How would economic booms/busts affect it?
6. What are the worst case scenarios? What could go wrong?
7. Financial analysis — P&L, tax impact, financing options, downpayment flexibility (very illiquid), initial estimated repairs, etc. 8. Legal analysis — zoning issues, easements, property title issues, locality department issues, neighbor issues, etc. etc.

Couple additional points:

1. Decent real estate attorney representing one's interests can save from numerous headaches (especially true in foreclosure/short sale cases). 2. Avoiding a buyer's broker saves one money, gives additional negotiating room, makes the seller's broker more willing to work extra hard for the deal. 3. Inspections are money well spent, even if one does not end up buying the property. 4. The market is generally very efficient (yes even during this recession). Why has the property one's considering not sold yet? etc.

I hope you find this useful.

Jim Rogers writes:

The rule of thumb I've heard used is 1% of sales price should be equal to or less than comparable monthly rent (that's a little more aggressive than Tim Melvin's measure, especially when you factor in the mortgage tax shield). I'd say, use either and stick to your guns.

Sam Marx replies:

Don't trust what the real estate broker says about a house's value or price. Do your own research.

Try to find prices of recent sales of similar houses in same neighborhood.

Check with the local banks to see what houses they now own and what are their asking prices.

If you can go to foreclosure sales, do it, not to buy a house but to get an idea of what the market in houses is and remember those prices when negotiating with a broker.

I don't recommend buying at a foreclosure unless you're experienced at it.

Don't be shy about making offers 25-30% below asking price when dealing with a broker.

Watch for estate sales, the heirs are motivated sellers.

I don't know your area, maybe it's reached a bottom, but in FL, housing prices are still too high. The stock of St. Joe Land (JOE), FL's largest landowner, was 69 a few years ago — now it's 15.

Phil McDonnell advises:

 Buying a first home can be a frightening prospect. It should start with a realistic look at your needs. How many bedrooms and baths do you need now and in the future? If your life involves one or more women strongly consider the extra bath. If you have the skills a fixer upper my be of interest.

I frequently advise my Realtor wife on the statistical aspects of our local real estate market. Pricing in this market is especially tricky. It is a declining market but that also means buyers have much more negotiating leverage. To measure your local market ask a local Realtor for the latest stats on number of homes on the market and number of sales in the last few months in your area of interest. For a normal market this is about a four month supply of homes at the current monthly sales rate. In this market it is running about 10 months of inventory per home sold. Hence the declining prices as sellers compete. One should consider staying out of the market until the inventory show signs of declining. However do not be fooled by a one month decline in local inventory. Buyers in the Seattle area are negotiating prices an average of 4% below asking. Get the similar number in your area.

As a buyer in this market it is best to view the prices as a price distribution. Suppose we have ten houses in your area. But only 1 will sell in the area in the next month. Clearly it is most likely to be the one that offers the best value on a relative basis. The other nine are over priced for these market conditions. By staying on the market for another month they will probably lose something like 1% in value per month.

There is an old saying in real estate. One should buy the least expensive house in the neighborhood. Generally this is true. After numerous regressions on homes it can be said that among comparables the most important single factor is square foot of the house. For the best resale find out which area has the best schools. Even if you do not have kids the people who ultimately buy your home may have them and it will help resale in the long run.

Check out all the government mortgage deals and tax subsidies. They are offering a tax credit of up to $8,000 for first time buyers. 30 year fixed rates are below 5%. The military may offer even better deals. Remember the $8,000 credit is only paid the following year via a refund so you do not have it to use as a down payment. It is more beneficial the smaller the house you buy. I saw a recent home sold for something like $80,000 in Killeen. The $8k represents 10% on that home, but only 5% on a $160k home.

Dr. McDonnell is the author of Optimal Portfolio Modeling, Wiley, 2008

Henry Gifford adds:

Home prices, in general, are still falling in the US, therefore waiting will probably bring lower prices.

As property prices fluctuate, one sign of high prices is easy loans. Times when prices are better tend to be times when loans are hard to get, with of course reasons for this relationship. But, as an affiliate of the military, there are sometimes special deals available to you that are not available to other people, which means you can be one of the few buyers out there at a good time to buy. Some of these loan deals only exist on paper now, as the price limits and interest rates make them impractical, therefore nobody talks about them, but because they are government programs which get updated slowly, and usually out of sync with the market, they can be really good deals at times. Therefore there may come a time when you can get both a good price and a good loan.

Buying near a military base involves risk of base closure (I owned a whole bunch of houses near a base that closed) or downsizing, and since you're in Texas where there is lots of land, upsizing the base won't put much pressure on prices - people will simply build more houses. Perhaps you can ask around inside the gates to get a feel for this.

Buying and selling property involves large costs for brokers, taxes, title insurance, etc., which penalize short term ownership, meanwhile you can get transferred to another base at a moment's notice, which puts you in the position of being in a hurry to sell. If, instead, you buy a commercial property, you can own it as long as you live, with far less management headache, which makes owning it while living elsewhere more realistic than renting a house to someone.

Phil McDonnell responds:

I think the truth in this statement is based on a defect in the way people perceive value. Suppose the average home in a neighborhood sells for $500k but yours is worth $400k. Then if the average goes up to $600k the innumerate masses will think that all homes have gone up $100k not the 20% they really should have. When they do this the $400k home appreciates by 25% not 20%. In other words people add when they should multiply by a percent increase factor.

Dr. McDonnell is the author of Optimal Portfolio Modeling, Wiley, 2008

David Hillman writes:

Another part of that defect is focusing on the value of the improvements v. the value of the land.

Some years back, a close friend bought a lousy house on a great piece of property in the best neighborhood. Even though it was a prestigious address in a 'branded' area, he got a deal on the property because the house was so undesirable. The plan all along was to demo the house and built a new one to suit, which is exactly what he did. He had realized the land was worth perhaps 90% of the true total value of the property before the new construction.

Many county auditors, etc. have searchable tax records online with the assessed values of land/ improvements parsed out. One might use that to figure a reasonable estimate of market value of land v. improvements. Don't forget the old saws apply….'land, they're not making any more of it'….and….'location, location, location.'

Bill Egan writes:

In the last 10 years, I have bought three homes and sold two. Did not plan to, but that's the way it worked out due to job changes. Sold both houses in < 1 week for a profit despite forced timing. We were not in subprimeville, either, and the last sale was 2001 before the real estate madness.

My wife and I kept resale value in mind because you never know what can happen to you. We made sure we bought homes that were average to excellent on the following criteria:

  1. School quality
  2. Exterior appearance and interior layout — good and normal
  3. Quiet, safe neighborhood that looks good
  4. Reasonable size (3/2 or larger)
  5. Likely demand due to commuting routes/distance to jobs

For example, I was working at a biotech in NJ from 1999-2001. We bought a 3/2.5 in a newer development, nice neighborhood in Burlington County, right next to an average-quality elementary school. However, the area was less horridly expensive than the homes closer to Princeton, where I commuted to. There was strong demand from people priced out of the homes closer to NYC/Princeton.

Rich Bubb replies:

1.  look at the neighbors. C-L-O-S-E-L-Y… look at the state of their domiciles (even getting "invited-in" for a look see if at all possible), and the state of the upkeeping… especially the immediate next door folk. You might end up living next door to your own personal nightmare. Believe me, it is Not Enjoyable. Even after almost 20 years. Thankfully everyone else on the entire block is somewhat more sane and respectful of their neighbors than my nextdoor nightmare. Or to put it another way: you might get the best deal that no one else could stand…

2. if you really know somebody in the real estate biz (my sister is an agent), have them look around for you. she got her daughter's family a fabulous deal in a great neighborhood. Or to put it another way: sometimes real professionals Do Know what they're doing.

3. look long at the deal, bid low for the deal (Game Theory might help a little here, here is a cool intro), then be prepared to walk away… even if not doing the deal means you'll have to go back and start the whole search-etc process all over again, and don't put pressure on yourself or let anyone pressure you into buying. My wife was not prepared to walk away from her last car purchase. She still got a good vehicle, but she could've strengthened her bargaining position by uttering the words, "Let me think about it." And then purposefully heading for the door. We went outside and argued between ourselves about leaving. She *wanted the vehicle*. It cost her almost $5k more than I wanted her to pay.

4. Consider the cost of long term ownership. I mean, Really figure it out… what's the cost of x, and y, and z, and can you afford it if those costs all hit at once.

5. Tangentially to #1 above, if there'll be kids living next door… would you:

(a) invite them in?, or

(b) chase them away?, or

(c) start scouting for really out-of-the-way burial sites?, or

(d) let them borrow your most deadly power tools?

Just mentioning this as my siblings and I were the 'b-c-d' and almost always the Never-more-than-once 'a'. And the neighborhood's less-than-model parents would often let their barbarians-in-training train at our place… Or to put it another way: your neighbors' kids might have fiends, er friends, worse than they already are…

Hmmm, karma might really exist…

Russ Herrold adds:

A anonymous blogger, 'Benjamin.Publicus' on Thomas Paine's blog  had this this observation:

… The author lives in a community that is (or was) at the epicenter of the mortgage crisis. The developer aggressively marketed the homes to young, first time home buyers, many of whom renters. No money down, own instead of rent, mortgage payments the same as the rent, etc, etc. The development was started in 2001, so the first wave of 5 year ARM's hit in 2006.

…and it goes on from there.

I have spoken to that author (and a couple others) about contributing to DailySpec, but he has been busy.

Dr. Herrold is Principal of Owl River Company, a high-end Unix consultancy

Rich Bubb adds:

As mentioned previously, my sister is a real estate agent. following are her comments on home shopping & buying.

Get a Real Estate Agent to represent YOU as a BUYER. Sign a contract as such. Tell them what YOU want.

There are surely things important to you that you would like to have in one of the biggest investment decisions you will make.

TAKE NOTES of likes/dis-likes of each home you view. re: Basement, Garage, Four Bedroom, Square Footage, LOCATION. I stress location because it can make or break the satifaction of your purchase.

Drive through the neighborhoods you are considering at different times of the day to see what the atmosphere is.Pay attention to the neighbors up keeping of their property. Schools?, established neighborhood?, new additions? child / adult ratio?
Comparison shop, don't just jump at the first home you look at just because you can afford it. Ask your agent to provide you with a CMA (a market analisis of a surrounding area - 5 mile radius ).

Get pre-approval from your lender, look at homes a bit higher than your range and offer LESS - the worst that can happen is, they will say NO or counter-offer and you may wind up with a nicer quality home.

BE Strong in making the decisions of your offers. Be prepared to give and take.

Then BE PATIENT thru the purchase process which seems like it takes forever because we are a see it, buy it, want it now, kind of people. It is a process that is in place to protect you. re: CLEAR TITLE

Again, don't just settle for a home, get as close to what you want as possible.

Feb

12

My grandfather (1885-1989) was the greatest teacher and influence in my life. His love of life and adventure was unparalleled. A true Renaissance man, he was comfortable with everyone from janitors to presidents. Since he always wrote everything down and was making lists, he once gave me a list on how to live my life. A truncated version:

1. Pay your bills on time
2. Pay your gambling debts first.
3. Never do business with a friend, but allow a friendship to develop out of a business.
4. Never, ever, cosign on a note.
5. Always buy bonds when they hit 60.
6. Always treat everybody at a business, from the bottom up, like he was the president of the company.
7. Always buy real-estate on the cheap.
8. Never touch the capital, and save part of the interest.
9. Live well below your means.
10. Never allow friends to know how much money you have and always "cry poor."
11. Spread your money and investments around.
12. Never lend more than pocket change to friends.
13. Family first in everything.
14. Congratulate your opponent when he wins, and be gracious when he loses.
15. Don't be a deal hog, and leave something for the next guy.
16. Speak little and listen a lot.
17. Never be afraid to say no.
18. Learn poetry, history, philosophy, and a second language.
19. Keep current in events, and keep an ear on the street for opportunities.
20. Learn good manners.
21. Treat every woman like she was going to be your future wife.
22. Don't trust the government, and never trust politicians.
23. Circumnavigate the globe at least once in your life.
24. Big game fishing is a manly pursuit.
25. Don't ever get drunk in public.
26. Don't ever embarrass yourself or family.
27. Never complain about your family to outsiders.
28. Teach someone your business and pass your skills along.
29. Never listen to race track touts or tipsters of any kind.
30. If they're selling it, why is it such a great deal or opportunity.
31. Never cheat at anything, nor be dishonest.
32. Never welsh on a deal or wager.
33. Always keep your promises.
34. Pay your people a fair wage.
35. Never pay retail for anything, but don't be a hog.
36. Allow your opponents to save face.
37. Never keep a mistress within 300 miles of your home.
38. Always give a guy on hard times some spare change.
39. Support a charity.
40. Be a stand up guy in all areas of your life.
41. Respect the flag.
42. Respect and listen to old people, as they know more than you do.
43. Work as hard as you can and play as hard as you can.
44. Keep your house and business tidy.
45. Allow your kids to be themselves and have fun.
46. Learn to play at least one musical instrument.
48. Respect other races and nationalities.
49. Never argue religion or politics.
50. If it sounds too good to be true, it probably is.

My grandfather was full of life lessons, and I listened.

Sushil Kedia adds:

Here are some more important lessons to consider:

1. Other Points of View (OPV): Accepting, rather than denial or immobilizing fear, is the beginning. The situation definitely gets refined when one looks at it from Other Points of View. One must look at the situation from the views of ones adversaries as well as from the perspective of an unengaged onlooker. Dispassionate observation is facilitated by comparing OPVs with one's own view and building up a strategic process that is always computing the odds.

2. Grow beyond wrong and right: Anger originates as sequence of feeling wronged and guilt originates as a sequence of having done wrong. In winning, it is crucial to be beyond computations of wrong and right. Focus instead on what defines winning for you and what is appropriate for achieving that win.

3. Economy of Movement: Decisive action including communicating the bare minimum necessary innuendos (action as well its absence are both communications) not only helps conserve energy it consumes the energy of the adversarial situation or people.

4. You are the problem: The same situation involving another man has another solution. Recognize your unique gifts and the precious effort that must go in to defending and growing this uniqueness. No handicap is thus in the middle of battle a drain on your resources. Viewing the complete picture with you at the center of the problem is necessary to identify the path of least effort applicable to you.

5. Be your own decision maker: Responsibility for all outcomes is the facilitator for achieving a focus beyond destiny and helplessness. Assume no help will come but will have to be obtained.

6. Don't celebrate your success, in the usual way: Deception is an ingredient of every contest. Feign strength when weak and display weakness when strong is something Sun Tzu taught centuries ago, in any case.

7. The Pain gain formula: Nothing comes free. Pain & gain are often the two sides of the same coin. Always check if an advantage achieved or to be achieved has not come or will not come at an unfair cost incurred unknowingly elsewhere. With such a focus the need to enjoy the journey is extraneous. What may begin with pain could be the ticket to gain and vice versa. The driver of joy being the final destination, the journey will become worth engaging in all situations.

8. Beautiful mind: Beauty of cause is a state of the mind. Being conscious that the mind has states and one can by conscious choice alter those states one may overcome the definition of mind as espoused by Edward de Bono that, "mind is a self organizing pattern seeking system." You and the situation together are the problem. Be conscious of your cognitive states.

9. Believe that you will succeed: You cannot argue with this point since as much as is true that seeing is believing so also is it true that believing is seeing. The solution and the current moment are separated in time. In traveling across the correct strand of time, one would need to traverse the correct strand of time. Believing is the lens to find the correct strand.

10. Be the witness: Changing the perspective from being the doer to one who is a witness to the struggle drives objective and rational sides of the self organizing pattern seeking system called the mind. Fear and hope that are the normal controls of minds in normal states need to be put aside whilst input and output control need to take over.

11. Do, only whatever is necessary: One can always be aware of not creating more problems while solving the ones at hand.

12. Give up when required, only temporarily: need for rest, rejuvenation, re-organizing apart. Many times silence, inaction, inactivity provide the ultimate deceptive veil for more lethal and smashing action.

Jim Sogi comments:

The Pain gain formula: Nothing comes free. Pain & gain are often the two sides of the same coin.

I love this, and Jeff's list too. But I wonder why pain and gain are so correlated? Is it the issue of going against the herd vs the genetic urge to comply? It applies in physical fitness. I sure would appreciate some ideas on this one.

Jim Rogers replies:

Pain is a necessary, but not sufficient, condition for gain.

Additionally, not all pain produces gain, but both concepts are relative. Because of the differences in both pain "tolerance" and measurements of gain (in terms of "value"), it's pretty difficult to turn this observation into any type of concrete maxim.

Finally, it seems that there are occasions where the value of a gain outweighs the pain endured, indicating some type of arbitrage situation. However, the pain of spending one's time looking for free lunches (combined with the "pain" of acquiring the skills to recognize arb opportunities) may minimize the net gain.

Alston Mabry writes:

What about that special pain the Mistress inflicts with volatility? One takes a position that then goes against, and one has to try to wait it out until it turns back in one's favor. So many times one gives in, escapes the position and the pain, only to watch the fulfillment come in exactly as predicted. Book the loss, learn the lesson, try again.

Marion Dreyfus responds:

You cannot win a great body without heavy working out. You don't fall into piles of earnings and wealth–you invest judiciously. Pain is obviously correlated to gain — otherwise we would leave the womb and float through life with strawberry sundaes glissando-ing off our lanais as we polish off language texts in the Copacabana with cognac fountains spurting gleefully in the front 40. We don't. We have to work to elicit goodies.

Aug

6

CartA friend of mine bought 10 hot dog carts for an initial investment of around $65,000. He employs a crew of young girls that wear clothes more suitable for the beach. He parks the carts in the right of way on the highways, and his stands always have a steady stream of business, regardless of the weather. He's reluctant to mention just how well his venture is doing, but I suspect that he's making a nice income from the carts. When he first started the business, there was quite a bit of negative publicity in the local press due to the offense that certain segments of the population have regarding beautiful women in bikinis selling hot dogs. He regarded the newspaper publicity as good advertising. Since no laws have been broken and he has complied with all the numerous regulations, they can't kick his carts off the corners. The free market will always fill a need or vacuum, and there seems to be a need for bikini clad girls manning hot dog carts in Southwest Florida. As a side note, our local police seem to be very good customers, and eat a disproportionate number of hot dogs for lunch. Now, only if a good BBQ place would follow suit.

Allan Millhone wrote:

I see on the news that a bikini barista in Belfair, Washington has been closed because of the scantily clad women serving coffee. Down the road in another town one drive-through remains open and partrons like the concept of the women wearing 'pasties' as they serve up coffee. Creative marketing or simply exploitation?

Jim Rogers takes it one step further:

I'm sure it offends the sensibilities of some, but various businesses have tried this kind if tactic in the past (e.g. there was a topless hair salon when I lived in Las Vegas called "A Little Off The Top"; no, I never tried it, since my dome has been topless for quite some time). Most of these businesses get put down under the auspices of health code ordinances. However, that usually takes long enough for investors to get decent returns.

George Parkanyi extends:

You know, that's not a bad idea for Paulson to move some of that mortgage dreck. Twenty cents on the dollar and the surface area. It works. We'll call it Securitized Hooters — SHooters for short — featuring at each kiosk "blonde traders" and a hot photo-shoot cut-out of a lingerie model we'll call, say "Fanny May" (giving it a more wholesome farmer's daughter twist). Jeff, I think you've solved the credit crisis.

May

5

This web site's contributors and readership consists of astute individuals looking to make informed investment decisions (or perhaps, more appropriately, trading decisions). However, it's worth remembering that many participants in the market maintain positions based on less objective criteria.

While taking a break outside today, I encountered an older gentleman returning to his workplace (a large diagnostic laboratory where he delivers lab samples to and from doctor's offices). He asked me what I did, and I replied "Investing", without going into great detail. He then asked me jokingly if I could get his investments back out of Enron. He then proceeded to explain that he had lost the majority of his 401K as an employee of Enron (he had been a petroleum engineer at a company acquired by Enron for over 20 years, then spent several stints with Enron in Houston). He reminisced that many times he had ridden on the same elevator with Ken Lay and Jeff Skilling, and had been told repeatedly, "Make sure you're buying that stock, T*****!" Now, at 76, he's a delivery driver, happy that his diabetic wife gets free lab work, but unlikely to retire any time soon. One can only hope that his eyesight and reflexes enable him to retain his current position for the foreseeable future.

After he walked away, I thought about my own fortunes. My first job in finance was with a firm that will soon cease to exist, and my immediately previous position was with a firm that recently announced substantial job cuts worldwide. Both firms pushed their risk boundaries past what might be considered reasonable bounds. Neither appears to have engaged in the fraudulent activity associated with Enron (as far as we know), but they may have arguably breached their "duties" to their stockholders in their pursuit of profits with insufficient regard for downside risk. I'm fortunate to work for a small firm that engages in high risk investment (seed and early-stage venture capital). The risk is high, but transparent and straight-forward to those who participate.

How often do we as investors/speculators encourage risk-taking behavior that bundles up participants who are unaware or uninformed about the risks involved? We can argue that anyone who takes an equity stake in any enterprise has the duty to inform themselves about the nature of their investment. If that is really the case, though, does some type of duty exist within the corporation to insulate and diversify their rank and file employees who serve in functional positions with little strategic input? Would doing so cool the market for high growth stocks, and would that chilling effect ultimately prove less expensive that the potential social burden that results from the destruction of shareholder value if and when things blow up?

Many people here have made and lost fortunes (some more than once). The difference would seem to be that the DailySpec readers were probably easily classified as willing participants. Does a duty exist to make a firm's members aware of the risks of stock concentration at least, and risk-taking strategy implications at most? I think many will state that we are all willing participants. However, we should remember that when things go the wrong way, collateral damage occurs. The question I suppose that I'm posing would be how much of that damage is needless. I can only thank reason and fortune that I'm in a good position now, and hope my new friend finds a way to enjoy some part of his golden years, even if they're not turning out as he planned.

Stefan Jovanovich adds:

"Everybody cheats" (See Breaking Away). Allowing companies to adjust the forecast rates of return on their defined benefit plans' portfolios was the way everybody in management cheated under the "old" pension plans. Allowing companies to contribute their own paper to 401(k) plans instead of cash has been the way everybody in management has cheated under the new pension plans. But it would be disingenuous to claim that the knavery is only in the board rooms. The poor, lowly employees in Enron had their own part in their financial ruin. The cheating in Enron was not just done by the senior managers of the company; it was endemic throughout the company. So was the boosterism for the stock and its price. The peer pressure to "buy the stock" came as much from lower and mid-level employees as from Lay and Skilling. Once "ordinary" (sic) employees come to "believe" in their company's stock, they become the most emphatic preachers of the new financial faith. People know when they are being greedy or lying to themselves; the question is what they do about it. Some or none or all of this may apply to the poor soul Jim Rogers met. 

Russ Humbert expands the scope of the analysis:

Why risk management is taken for granted or ignored:

1. Everybody is a genius when things are going great… It couldn't be that you got lucky. A good risk manager reminds everybody they are not as smart as they think they are. A good risk manager tells them to walk away from the table, or at least take some chips off of it. Which is always interpreted as "you are preventing us from making money". It is very hard to argue with success, if it's the gambler that just threw 4 straight 7s to Buffet at his annual meeting.

2. When everything has gone to Hades a good risk manger can't win. First he has to convince them that there are no excuses, take your losses like a man. Certainly there will be someone to blame, from the con-man to the incompetent fool; the loss could have been avoided. Learn from it. In investing, everyone has a choice. In 401k a good variety of choices with proper accounting for $ should be the only obligation from the business. Second, he has to direct them to the opportunity in the panic, rather than look for the scapegoat. When things are bad, risk is always overestimated by someone needing an excuse to cope out of making scary calls and implying nobody is to be trusted. Hurricane and earthquake insurance premiums increase after the fact. Try convincing managment now is the time to be in earthquake business when everybody is wanting to buy it.

3. Many believe risk management should be free. (For an example, look no further than nationalized health care). Nobody wants to pay for the research and personalized understanding that takes time and money. Ask your superiors for resources, on something they consider a sunk cost that constrains them, and they are not interested.

4. Many believe investment risk management is simple common sense, which can easily be regulated. Working for an insurance company, and seeing the high regulations imposed on insurance companies investments, it's clear regulations and common sense don't mix.

5. Many believe risk is not a personal choice and a cookie cutter approach for everyone works fine. Think of the millions that have suffered and died due to FDA's approach. But with personal choice comes personal responsibility. Tell this to the risk addict. Or tell this to the insanely paranoid.

6. The Lake Wobegon effect where every child is above average, clearly applies to investing. In a investing/business you can always find a area where your business does a better job of managing risk than the rest of the industry. Or if not the industry average, you can find someone that does a more shoddy job than you. Hence, you are above average in every aspect. Further it never occurs to you that everybody may be lemurs headed for the cliff. Try being the risk manager to a disfunctional buisness, I think I would rather tell a Mom her son can't move on to the next grade.

7. A close kin to Lake Wobegon is many believe they are "blessed" and therefore can ignore purdence. While risk management applies to the masses, they got G*d on their side. If its simply because they were born to the right parents that their luck can't run out. Or it could be the opposite, they have had such a string of bad luck that the Big Guy owes them. Pity the poor risk manager arguing with this.

8. The Rating Agencies are thought to be better than internal controls. Nobody considers that the ratings are a game and are often exploited. This has many parts:

a. As I wrote in an earlier post, the subprime mess is largely due to socialist industry averaging of risk management.

b. When the game is to get the rating, not to manage the risk, there are a million loopholes. Simply learn what they review, and take your risk elsewhere (hopefully this increases your returns). Hedge funds/Sharpe ratio, go with liquidity. Investment banks balance sheet, move them off balance sheet with SIV's. P&C companies, do reinsurance with side contracts like AIG and GenRe. Life and Annuities insurance companies, use variable annuity guarantees and interest rate guarantees (which are now being monitored after large loses)

c. It seems Enron bought their rating. From the magazine ad claiming "Car of the Year" to Nobel Prize. You should assume raters have some price: dollars, political, or connections and you should not consider them totally objective.
 

Jan

9

McDonaldsJust caught on the news that Mc Donalds will add a 'coffee bar' and make more dramatic changes to their drink menu than they have in the past 30 years. I enjoy their Bravo coffee and am sure I will enjoy the drink additions when they reach my area. Mc Donalds is apparently still setting the pace in many areas as it was also announced that Starbucks now plans to make changes.

Sam Marx adds:

Although Starbucks gets a different niche of customers, this not good news for Starbucks .

A coffee bar and wi-fi at McDonalds, then Starbucks really has a problem.

Adam Robinson reflects:

I've always believed that the ethos of a corporation pervades, DNA-like, throughout all manifestations of the corporation, however small the "cell." If you want to discover the values of a company, you can look anywhere, from its choice of stationery down to the cleanliness of its floors.

Back to Starbucks. It was telling for me regarding the company's values that, living as I do five blocks from the former World Trade Center, I was shocked that in the days following, when rescue workers, many of them volunteers, flooded the area to begin cleanup, the local Starbucks was selling bottles of water. I'm as much a capitalist as anyone, but the outrage this opportunism occasioned in the local community, and subsequent bad publicity — Starbucks quickly reversed its policy and began handing out bottles for free – rankles to this day. The positive publicity it could have garnered by donating the water to relief workers would have more than paid for the negligible profits "sacrificed."

Ray Kroc was fanatic about cleaning his stores, and making everything perfect. Moreover, McDonald's franchisees are a powerful force for innovation and market research. I doubt that Starbucks has any such credo. And were I a fundamental investor, I'd bet on McDonald's in the race with Starbucks.

Ryan Carlson adds:

A worthy read about McDonald's is Ray Kroc's Grinding It Out. My favorite passage:

The key element in these individual success stories and of McDonald's itself, is not knack or education, it's determination.  This is expressed very well in my favorite homily: 'Press On: Nothing in the world can take the place of persistence. Talent will not; nothing is more common than unsuccessful men with talent. Genius will not; unrewarded genius is almost a proverb. Education will not; the world is full of educated derelicts. Persistence and determination alone are omnipotent.'

Henry Gifford dissents:

Starbucks and McDonalds offer entirely different products in terms of the cultural experience they sell.

On Broadway in Manhattan, two blocks from me, there is usually a homeless person "working the door" at the McDonald's, opening the door for customers and asking for spare change. Once McDonald's put a guy with a bow tie there to open the door for free, but that didn't last long, and the homeless guy is there every day. Also, the workers in McDonalds don't hesitate to stand around and chat and ignore customers.

At Starbucks a block away I've never seen a homeless person "working the door," (nor at any of the other stores nearby), I don't see homeless people sitting there, and the workers have a spring in their step.

Jim Rogers counters:

As someone whose first career was in the hospitality industry, I can state that McDonald's moves markets in more ways than one.

The difference in demographics, however, is a present condition and certainly not a necessary condition. McDonald's has always put its eggs in two baskets: families (especially those with small children) and value. In the past, their offerings were weighted more heavily on the family side of the spectrum. Now, thanks to a number of cultural shifts (including those driven by Starbucks), McDonald's has realized that they can capitalize on the public's perception of additional value. Before, it was all about quantity (the Super-size phenomenon). Now, it's about quality (better coffee, more aesthetically pleasing decor, fresher menu items). In the past 24 months, the majority of McDonald's top line revenue growth has been driven by menu items at the top of the price scale, especially new salad offerings. There are a couple of interesting points that McDonald's has embraced: the masses (or at least a historically large percentage of the masses) will pay for quality, and design makes a difference. It made a difference in attracting the kids thirty years ago, and now it's making a difference as it re-attracts adults (with or without children) with Wi-Fi, coffee, and more pleasing decor.

Marion Dreyfus opines:

Whatever the relative merits or demerits of the individual loci, the Starbucks habituee will not 'descend' to the perceived downmarket of McD's, which is a brand-association drummed into our consciousness by millions of ad messages over decades. The food may be better, the prices definitively so, at McD's, but the smart set will not cotton to the overbright, plastic-dominated perceived lower-ranking environment of kid-friendly McD's.

The escalation of prices for a simple beverage to unheard-of stratospheres is one thing that has, to date, ensured the rarefied perception of Starbuck's as being compatible with the upward-striving status-jumper.

So unless McD's radically alters its branding, the trendoids will find it distasteful to step lively in those swinging doors, even if their coffee tastes more acidic and sets them back more by a factor of twice or thrice the McD's coffee.

Ken Smith comments:

Ronald McDonald is five blocks east of me in Seattle, a short walk downhill a ways. Property they have is also just a short walk uphill to Childrens' Hospital. Parents can stay at Ronald's place while visiting kids, many with cancer. Ronald's facility is commendable for its architecture. One can have nothing but praise for Mr. Ronald, whose plastic body is standing out front of the facility, smiling with welcome. Kids love him.

Vitaliy N. Katsenelson analyzes:

SBUX stock is transitioning from 'growth' to 'value' investors. However, it is not cheap enough for value guys. At least not yet. Also, with current news cycle it will likely see the other extreme of its valuation. In the not so distant future it will probably have to rationalize its store base, close some underperforming stores and slow its growth expansion.

Jim Rogers notes:

Fast-food restaurants, due to their staffing policies, are much more likely to employ legal immigrants than you might think. The biggest offenders in the food world for using illegal labor: high-end restaurants, because they lack the institutional oversight and back-office support to adequately check a lot of prep cook and porter staff applications (and some are simply dishonest). If you're looking for a trade opportunity in the event of some strict anti-immigration policy, short higher ticket restaurant groups.

Scott Brooks writes:

McDonalds will have to work hard to overcome their persona. They have cultivated that image for a long time. I have often joked (with an air seriousness to it) that one of the greatest inventions/innovations of the 20th century was the McDonalds Playland!
 
I absolutely hate the food at McDonalds and will move heaven and earth to not eat there. But my kids like it. So when the wife needs a break and the kids want to go play, I'll take them to McDonalds, buy a few Happy Meals and let the kids play and eat.
 
Actually, they don't so much eat as graze. They play, come back and grab a few fries and bite or two of their burger/McNuggets and go back to playing.
 
As much as I don't like the food at McDonalds, they are an incredibly innovative company that I respect immensely. And with their distribution chain and the demographics of America changing, don't underestimate what McDonalds is capable of.
 
That clown may look stupid, but underneath there is a shrewd businessman!

Nigel Davies ponders:

I'm just wondering what the real appeal of McDonalds is and what really gets people in the doors.

I often eat at McDonalds during tournaments because there's usually one around, probably they won't poison me and if they do (and I live) I can sue them.

On the other hand my five year old son much prefers the relatively civilised atmosphere of Pizza Hut, so much so that I can use the 'Would you like to go to McDonalds for lunch?' gambit as a threat. Now it turns out he quite likes pubs that do food, but the big thing here was getting him in the door and outside his comfort zone. Now he does miss the balloons but there again he's taken a liking to turkey.

So it seems to me that a lot of this is down to parental choice, the main driver here being cost. Of course most parents are going to be struck by severe pangs of guilt should there be even a whiff of a rumour that the food served up is unhealthy. So with BSE (Mad Cow Disease)/cholesterol etc appearing on the horizon, it was inevitable that McDonalds would take a hit until it overhauled its menus and image.

In this respect I see the coffee/WiFi as being a really clever means of making them look like Starbucks and feeding off the modern, trendy and healthy image of the coffee house chains. But are they a 'competitor'? I really don't see it, and I don't see a Starbucks denizen suddenly switching to McDonalds because of the cost. To me it looks more like an image thing to get the old customers back in the doors.

Julian Rowberry submits:

Starbucks never really caught on here in Australia. Its brand name and attempt at exporting US culture is a tad brash for the local market. Plus there's already a vibrant cafe scene. The Maccas Cafe has been here for years. It's aiming at the fast and convenient 'healthy eating' market that companies such as Subway feed on. Not branded wanker latte drinkers.

Alston Mabry recounts:

Burger KingAt Burger King the other day (I'm not a big fan of fast food, but I am a Coke addict, and my dogs love the burgers on the dollar menu), I hit the drive-thru, and when I pulled up to the window, the Latina there said they needed to cook the burgers and would I mind pulling into the parking lot in front for about three minutes (they know their cooking times). No problem. I don't mind waiting in the car because I always have a good book to listen to, this time Adventure Capitalist. I'm listening away, and the pooches are quiet in the back, when I notice it's been almost ten minutes. So I go back through the drive-thru, and there is a young guy at the window this time. I start to explain, and he thinks I'm placing an order. His English is good, but he is obviously from Mexico or Central America. I show him my drink and the ticket and he gets it and starts rattling away in Spanish with the staff. I realize he is the shift manager. He comes back, apologizing profusely, and explains that they accidentally gave my food to somebody else who was also waiting, that they will cook fresh burgers for me and that he will bring them out to me personally. I think he was worried that I would be angry, but I wasn't at all. We park again, and a few minutes later he appears with the food and apologized otra vez.

The point of the story is this young guy. He was a good-looking kid, maybe twenty. He was running the show, working hard on his English, taking reponsibility for the results, apologizing for mistakes and personally delivering the goods. And here was Burger King providing the structure for him to be successful. Not a dead-end job at all, not for this guy. I was very impressed.

Scott Brooks adds:

I had an funny thing happen in fast food to me in about 1985. I was a manager of a Taco Bell, putting myself through college. We had hired a new girl who had previously worked at Burger King. It was her first day and I had her working the drive-thru.
 
The drive thru "dings" with her very first customer. She says into the microphone: "Welcome to Burger King, can I help you." I thought it was pretty funny, she thought it was pretty funny, but the guy in the drive-thru began laughing hilariously.
 
But he placed his order and pulled to the window. The reason he was laughing so hard? It turns out he was the guy who owned the Burger King where she used to work.

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