3 Important Advantages the Small Investor Has Over Wall Street

Wall Street investors, hedge funds, and giant corporations have an almost incalculable amount of money, top-flight analysis tools and software, and a bunch of MIT, Stanford, and [insert Ivy League School] alumni to sift through the stock, bond, and real estate market for the best deals out there.

Equity Residential, for example, is a real estate investment trust (REIT) with a market cap of $31.2 billion and $2.6 billion in annual revenue. Invitation Homes, for its part, is the nation’s largest homeowner with over 80,000 houses (yes, that’s not a typo, eighty thousand houses) in its portfolio! (1)

How are we supposed to compete with that?

Luckily, contrary to your Marxist professor, these behemoths have enormous disadvantages when squaring off against small to mid-sized investors like the vast majority of us who make up the hallowed digital ground here at BiggerPockets.

Big Companies Are Bureaucratic and Wasteful

Any large institution is likely to leave an enormous pile of waste in its wake. The federal government, of course, takes the cake in this regard. What exactly is waste is, of course, debatable. But the numbers that the likes of Citizens Against Government Waste—$3.1 trillion in wasteful spending over 10 years (2)—or Senator James Lankford’s report including $473 billion (3) or just the sheer volume of “improper payments,” which according to the GAO were $141 billion in 2017 (4), are quite illustrative. As are some of the more specific examples, like the $175,587 spent to study the link between cocaine and the mating habits of quail (5), or just the outright grift like the $998,000 the Pentagon paid to ship two 19-cent washers. (6)

Us ardent capitalists would like to think that business is different, but it’s only different in terms of scale. Yes, the federal government is the all-time champion of waste, but large companies are notoriously wasteful and inefficient, as well. As one small point might help illustrate, Warren Buffet named his private jet The Indefensible because it was, well, indefensible. (7) Virtually every major corporation has at least one private jet, if not a fleet of them.

Indeed, if nothing else, one study found that businesses are losing $37 billion each year from just having unnecessary meetings. (8)

With regard to literal wasted product, at least one study found that the bigger the company is the more it tends to waste. (9)

“Waste—product that is made, but is unsellable—costs brands money and damages the environment… ‘We’ve found that 1-3 percent of a brand’s total production is wasted,’ says Jeff Denby, co-founder of the Renewal Workshop.’ At 100 million units per year for a big brand, the scale of 1-3 percent waste becomes huge. And, the larger the brand is, the more complicated their business operations, means that rate can increase to as high as 5 percent.” [Emphasis mine]

While Office Space wasn’t a documentary, most people who’ve worked in the corporate world recognize there’s more than a grain of truth in its depiction of corporate life and the sheer waste that went along with TPS reports (or their modern-day equivalent).

This waste and stultifying atmosphere offers a major advantage to smaller companies and entrepreneurs who have more skin in the game and more intrinsic motivation because they are usually owners or partners in their business.

Wall Street Is Formulaic

Multiple people saw the market crash coming in 2008, but few did much about it. One of those who actually did something was Greg Lippmann, who wanted to short mortgage-backed securities. Michael Lewis profiled him in The Big Short and notes,

“As [Lippmann] put it, ‘If you’re in a business where you can do only one thing and it doesn’t work out, it’s hard for your bosses to be made at you.’ It was not possible to do more than one thing, but if he bet against subprime mortgage bonds and was proven wrong, his bosses would find it easy to be mad at him.”

In other words, they want you to do your job and stick to it, even if it doesn’t make sense. Indeed, even when Lippmann convinced investors he was right, it usually didn’t help.

“But the most common response of all from investors who heard Lippmann’s argument was, ‘I’m convinced. You’re right. But it’s not my job to short the subprime market.'”

It’s not just about sticking to rules and policies (even when it’s absurd to do so). It’s also about the incentives that institutional investors and Wall Street have: Make money now!

Here’s how Gregory Zuckerman describes this incentive problem many faced when recognizing the same impending catastrophe prior to 2008 in his book The Greatest Trade Ever.

“A key reason even experienced investors resisted buying mortgage protection: CDS [Credit Default Swaps] contracts were a classic example of a ‘negative-carry’ trade, a maneuver that investment pros detest almost as much as high taxes and coach-class seating. In a negative-carry trade, an investor commits to paying a certain cost for an investment with the hope of untold riches down the line. In the case of CDS contracts, purchasers usually agree to make an up-front payment, and to shell out annual insurance premiums, both of which bake in a sure cost.

“If negative-carry trade doesn’t work quickly, the cost piles up. An investor paying 5 percent a year to place a trade will face 20 percent cumulative losses after just four years. These losses grant a running start to competitors, all-advised move in a world where trailing a rival by even half a percentage point can lead to a swift dismissal.” [Again, emphasis mine]

Entrepreneurs and small investors can have the opposite problems. Either not enough policies and procedures (some systems are necessary if you want to scale) or not enough working capital to be able to handle a “negative-carry.” But what we do have is no corporate board, CEO, or CNBC panel discussion to be held accountable to if we want to go against the grain of conventional wisdom.

Institutional Investors Aren’t Flexible or Creative

In the same vein, Wall Street, big corporations, and institutional investors are often quite inflexible, whereas we can be quite nimble. Indeed, finding such inflexible institutional investors is a key component of James Randel’s investment strategy. Randel focuses on commercial real estate and describes this component of his approach in Confessions of a Real Estate Entrepreneur,

“Many real estate players will use an expression about a challenging deal, ‘The property has hair on it.’ That generally means that the deal is ugly (think hairy gorilla) for some reason. It might be because the building is physically challenged, or it might be something else: a construction issue, a title problem, an environmental concern, a tenant revolt… anything that depresses the price of the property.

“These are the kinds of properties that my partners and I love. As entrepreneurs, we operate under the presumption that there is enormous money to be made finding deals with hair on them, especially if the property is in the hands of an “institutional” (non-entrepreneurial) owner. Institutional investors often own a large number of properties, many of which are located far from their corporate headquarters. Often, they do not have the time or the manpower to deal with problems that can arise with a property and so they may neglect to do the things a local entrepreneur would do. At times this can cause an artificial depression in the value of the property. I say ‘artificial’ because the problems that are depressing the value may not be fundamental or organic to the deal. A change of ownership, with a new, entrepreneurial approach to the problems, can mean huge added value in a very short period of time.”

Most large companies that buy portfolios of houses are quite rigid and only buy fully performing portfolios in nice areas because they just aren’t flexible (or local) enough to oversee the reposition of a portfolio of houses, especially if they’re in an OK or mediocre neighborhood. Indeed, when they do buy in lower-end areas, they tend to run into hardships from what I’ve seen. This is how we purchased the package of 41 houses a few years back.

Big companies tend to like big properties that are straightforward. When that deal gets “hair” or requires some creativity, they get lost in their own bureaucracy. This is a major advantage for the smaller investor.

So, take heart my friends. There’s plenty of deals out there and in many—perhaps even most—ways, the small investor has a distinct advantage over Wall Street when it comes to real estate.

Sources

Do you agree or disagree with my points above? I’d love to learn your point-of-view.

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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.