Downstream Investing

By Brad Thomason, CPA

If you’ve ever slipped a canoe into a stream you found out pretty quickly which way the current was going.  Canoeing on a stream is essentially an exercise in starting here with the intent of ending up there.
 
When performing investment analysis, it is often the case that the focus is simply on what the opportunity looks like today.  But for an asset which will be held any length of time, looking at the future picture is an important part of really knowing what you’re getting into.  It’s important to get a sense of what things might look like once you get downstream.
 
A popular newsletter advocates the idea of buying stocks of companies with a habit of increasing their dividends every quarter.  Why?  Because, that 6% yield you are buying today could morph into an 8% yield within a couple of years if everything goes well.  And if you get really lucky, that higher yield could also lead to an increase in value (i.e. because more people want the bigger dividend and buying pressure causes the price to rise).  So you’ll be earning more dividend income on your original investment and you’ll have an unrealized capital gain, too.  Smart idea, and good when it works.
 
Contrast this with something like a CD or a bond.  The terms you agree to are the ones you are going to have for the life of the investment.  Well, if the issuer runs into problems you may get less than you were expecting.  But you aren’t likely to get more.  There’s simply nothing about the structure of those assets which would lead to that sort of changing situation.
 
Now, it is fair to point out that technically, investing on the basis of something which could develop is not without risks.  It is in fact the very definition of speculation.  You can take anything too far, and this is certainly something to be careful about.  Venture capital (VC) investments are maybe the ultimate expression of investing in a situation today which you hope will be different tomorrow.  VC investors write-off a lot of situations that never go anywhere at all, in the process of booking the relative few that actually take off.  They are used to it and plan for it.  Us mere mortals usually find losses harder to stomach, and should invest accordingly.
 
One downstream investment which we’ve had some involvement with is an office complex owned by one of our clients.  The rental rates were initially set below market, in order to attract tenants and give the place a vibe of activity.  Ghost towns are harder to lease, you know.  This was possible because they got a good price on acquisition, and even with the lower rate the offices still made money for them. 
 
Fast forward a couple of years and occupancy was over 90% and open space didn’t sit very long.  So they started edging up the rates.  Overall return levels rose because the future picture was different than the picture on the day they bought it.  It was all just part of the plan, but the point is that they might not have done the deal in the first place if they’d only looked at the situation when it was empty space with no revenue.  
 
Another one we like: buying a rental house and putting a mortgage on it.  Even if the rents never go up and even if the property never appreciates, it can make more money in the future than in the present.  How?  Because the tenant is paying off the debt.  That decreases the interest expenses that are hitting earnings, and improves the owner’s equity position at the same time.  A double win.  Best of all, the initial rents are often a higher yield than the investor was getting on bonds or other investments, and at least a portion of the income may be tax-preferenced, due to the depreciation deduction.  You start out with a winning return and improve from there.  Hire a pro to manage it, and it’s no harder to own than something which pays a much smaller yield.
 
Investing analysis has to look at the merits of the investment on the day of acquisition.  Anything which may or may not happen in the future has to be understood as merely a maybe.  But that said, if you don’t look into the paths the future could take, you may not have a full appreciation of what you are investing in.  Ending up with a nice surprise is certainly not something to be too worried about.  But passing on an opportunity because your analysis is too one-dimensional is probably not where you want to be.