The Ridgewood Group Value Investing Blog

We’ve been cautious about real estate (especially residential real estate) for a few years now.  As a firm that focuses on value investing (quality when it is cheap or cheaper) we tend to have a contrarian orientation.  To paraphrase Buffett, when everyone is greedy, we often feel fearful.  Over the last few years, real estate prices have risen disproportionately in comparison to levels that could have been justified by the underlying fundamental drivers like demographics and income.  The divergence has been fueled by access to larger sums of leverage from an increasing number of undisciplined lenders.  Predictably increasing leverage fueled increasing prices which then also lead to a reflexive (as in George Soros’ theory of reflexivity in markets) shift in the psychology of participants.

In the last few months, the nature of this poor lending has come to light, especially in the subprime space.  However, there is a good chance that there are more shoes to drop (or as Churchill once quipped, “This is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning”).  Millions of americans today probably own more house than they can afford.  While incomes are rising, the unwinding of the leverage fueled bubble in real estate has probably only just begun.  As this purging/unwinding process picks up steam, there will undoubtedly be pain encountered by hundreds of thousands of borrowers and the institutions that lent to them.  Eventually, of course the Fed will respond to this deflationary headwind by easing and when it does, it will provide a bit of breathing room to the financial system.

Of course, the future is uncertain.  Large conservatively financed companies are generally out of favor and may holdup better if the above scenario is even partially right.  Being a value investor focused on purchasing these companies with a long-term view also doesn’t hurt.