Once, I assisted a great doctor and a hero. OK, I was an intern, and he was a financial planner with a Ph.D. in public policy. But the hero part is true. You see, Dr. B. hustled his clients safely out of stocks and into cash within weeks of the October 1987 crash.
That's the good news. The bad news is that he kept them out. What did you expect? The man was a hero. He dodged a bullet -- and saved his clients millions. Better to steer clear of a suckers' rally. Better to sit this one out. Within a year, stocks were hitting new highs.
It's going to be a long time gone
At some point, I suppose, I must have left school and gotten a real job. Meanwhile, the good doctor and his clients missed out on a 40% ramp off the bottom. If only that were the end of it -- I suspect many of them missed out on the greatest bull market in U.S. history.
I know the feeling. I've suffered the same fate -- mine at the hands of real estate. Or I should say real estate stocks. I even owned a builder or two back in 2000. But like a knucklehead, I took a tidy profit in anticipation of the "coming crash." I heard what I wanted to hear, then waited on pullbacks that never came.
Worst of all, I watched my favorite mutual fund of all time, Third Avenue Real Estate Value
This debacle ends here!
If you haven't been following, I've started investing out in the open, buying picks recommended in Motley Fool newsletters with my coworker Shana and her father. For the ground rules and some background on our little experiment, check out Daddy's No. 1 Stock Pick, but hurry back when you're finished.
Daddy, in brief, is the daredevil; Shana, the Victorian. The idea is that Daddy can roll the dice on high-quality growth stocks -- like, say, an Electronic Arts
Shana will counter with beaten-up value plays, blue chips, and dividend payers. Mostly cheaper, old-line outfits such as Mattel
When you need a fund
On the risk scale, I fall somewhere in between -- which is about where I place real estate as an investment. It's a great counterbalance to stocks, and nobody's making any more land, but it's subject to cycles, despite the generous dividends paid by real estate investment trusts (REITs). Which brings me to two further caveats:
1. Third Avenue Real Estate Value invests heavily in real estate operating companies (REOCs), as well as plain-vanilla, income-producing REITs.
2. Real estate, real estate stocks, and real estate stock funds have all been red-hot for going on five years now.
Together, these two factors push this purchase up the risk curve. But I'm taking the plunge anyway, and I'll tell you why.
Buying the bubble?
Am I crazy? Maybe, but hear me out. As stock investors, we'd all rather have backed up the truck in April 2002 than have bought a single share in March 2000. But, honestly, who knew, and who had the guts? That kind of discipline is hard to come by.
Even if you can sense the top, are you really inclined to buy after a crash, much less when something is out of favor? Learn a lesson from my first boss. If you have the discipline to fill out your real estate allocation when prices fall, then you might save a buck by waiting.
Otherwise, be done with it. Because here's the thing: Sooner or later, most investors should have some real estate in their portfolios. Ultimately, I'd like to get up around 10%. Right now, I have none. That's why I'm getting some now, despite the recent run-up.
Shopping for value
Fortunately, the skippers at Real Estate Value are value hounds -- even if I'm not. Indeed, whereas REIT funds typically approach the markets top-down and diversify like mad, Real Estate Value seeks out undervalued realty stocks from the bottom up. The goal is not for current income but for long-term capital appreciation.
Lest this sound simple, the team also invests in a range of mortgage-backed and debt securities. In some cases, this means buying secured notes of distressed companies at significant discounts to par value, offsetting the risk with derivatives. Don't let the word scare you. The fund uses derivatives as they were designed: for safety, not to add leverage.
Want some land with that company?
But the main course is premier real estate operators. Like The St. Joe Co., a regional developer that owns a huge chunk of northwest Florida, plus the vast majority of its developable shoreline. The plan is to populate resorts and planned communities with migrating baby boomers. Now that's a plan -- and a stock I've wanted to own for years.
Urban developer Forrest City Enterprise and Tejon Ranch, which holds a nice parcel of undeveloped land in Southern California, are other notables in the top 10. The company also held a chunk of Kmart Holdings
You start to see why the fund has been up each year since its inception in 1998. In fact, its 20.17% average annual return puts both the S&P 500 and REIT index to shame. And despite a fairly concentrated portfolio, the ride has been considerably less bumpy than its peers.
We can't all invest like legends
So let's put aside the thrill of selling high. Legendary investors buy low. That's why the definition of "low" remains elusive -- and why ratios and forecasts run all hours to justify or discredit today's prices or valuations.
The trouble is -- ratios be damned -- it's hard to "buy low" when something costs more in dollars and cents than it did one month, one year, even five years before. But if it's something you want, if it's something your portfolio needs, what can you do? You buy it and be quiet.
Fortunately, whether it's up or down, real estate offers balance. If you're looking for income you might consider a plain-vanilla REIT index, especially for tax-deferred accounts. If you're looking for an actively managed real estate fund with an eye for value, Third Avenue Real Estate Value is hard to beat.
One final confession
What makes this so painful is that I recommended Third Avenue Real Estate Value to the members of Champion Funds myself. That was September 2004. If memory serves me, I led with the same tired story about October 1987 and closed with the old "if it's something you need, buy it and be done with it."
If only I'd taken my own advice. As of Feb. 8, 2005, Real Estate value is up 20%, compared with 13.3% for the S&P 500 for the same period. To my displeasure, it's not even Champion Funds' top performing fund. Don't believe me? Shannon Zimmerman is offering a 30-day trial to Champion Funds. Why not take the trial and peek at the scorecard for free?
In a future column, I'll break down a new strategy I've devised (and implemented myself) involving exchange-traded funds (ETFs). But today's technique -- getting quick, diversified exposure to a group or asset class you ordinarily wouldn't buy on your own -- strikes me as a great use of mutual funds.
So, are we at the top for real estate? Maybe, but I assure you, we're not going to have this same conversation again next year.