Windfalls and how to deal with them

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“Rich people acquire assets. The poor and the middle class acquire liabilities that they think are assets.” - Robert T. Kiyosaki, Rich Dad, Poor Dad

Welcome to May! Unbelievable and as always we kick off with a bank holiday - or, as the Treasury like to call it, a bad day for the economy. Apparently they are looking at the viability of permanently enshrining the extra bank holiday this year - I would bet anyone willing 50p that that won’t happen……

This week I wanted to talk about windfalls - and the problem of turning capital into income, whilst preserving it, in general. Before we get into that important topic, and one that generates dozens of facebook posts across the property groups each week, a summary of the progress and updates in the macroeconomy this week is sensible - too much is happening, too quickly, to not put this into context.

Firstly - you may have seen a couple of headlines out of the US this week. Quarter 1 2022 has seen a GDP contraction. Yes - the smallest contraction - 0.1%. We also need to remember that Q1 is historically the worst performing quarter in economies that have a northern hemisphere weather structure i.e. winter in/around December to February - and it rarely sets the world on fire. Coming off the back of a Christmas period which generates more consumption than usual, into a time of year when free cash flow is more restricted for the average household, has to have a negative drag on consumption. The probability of a recession being in the now, in the US is very small, still. However, this is a warning shot to say the least - especially with the level of aggression being talked about with the base rate of interest rises at this point by the Federal Reserve.

The other is that the Nasdaq is down 13.3% for April after a 4.2% drop on the last trading day of the month. Amazon closed down 14.05% just on the day - at a $1.25tn market cap, that’s some haircut. A sensible interpretation of this is that the pandemic has flattered to deceive, and I’m sure that many a hedge fund has made a pretty penny betting on exactly this, especially after what happened to Netflix the other week. This is the worst week for the daq since October 2008, which many will remember as a sub-optimal month for the stock markets……

Big tech was the answer to the pandemic and it absolutely soared. Musk went from a “standard” billionaire worth circa $25bn to 10 times that in under 2 years, and he is now enshrined as the world’s richest person (currently) in the eyes of many. Now the chickens are coming home to roost and the reality that “this growth in customers and earnings can’t continue” is here. In the now.

It’s time to revise some of the economic reality that I’ve been discussing over the past 18 months and beyond. Firstly, after the 2016 referendum I coined the phrase “fakeflation” to describe some of what was occurring. In simple terms, the pound went down in value in compared to the major currencies in the world. The markets didn’t expect Brexit, and when it happened, they put in a major vote of no confidence against Brexit. 15-20% movement downwards in the value of the pound. This created inflation because we import so many of our goods, including a lot of our foodstuff. Inflation touched 4%. This was absolutely massive at the time because the economy starting limping along not much after that, and things were particularly flat in 2019 (and there were some recession indicators for 2020, where of course there was one, but not for any conventional or predicted reasons). It subsided, because that was a one-off shock to pricing.

The central point though is around the word “fakeflation”. Inflation SHOULD be a symptom of a healthy economy. It isn’t, right now, and it wasn’t in 2016/post-referendum. It was a shock effect based on something else happening. Right now in the short term it is due to supply chain disruptions, you could argue there’s medium term impacts of the want to de-globalize some of the world although that will take time to play out, including, now, zeroing dependency on Russia for commodities/energy, and lowering dependency on China.

That all sounds lovely, doesn’t it, but it is a destroyer of economic value. We don’t work with those countries because we want to - we work with them because they are the cheapest solution to our “problems”. Not working with them is gigantically inflationary over time. We need inflation that is the symptom of a healthy economy - this is exactly why the target is set at 2% by the government.?

This is the central argument at the moment around transitory inflation (it will go away - don’t panic - they say) versus secular inflation (it is a much more permanent phenomenon because of some of the impacts of the pandemic and the policies employed to counteract the pandemic). You can read into the above that some sounds transitory and some sounds secular (I hope). There have been disturbances to core inflation there that will persist and mean that the 2% target is simply overly hopeful alongside a growing economy.

The guaranteed way to fix inflation, repeated over and over again in the past, is a recession. It isn’t the only way out from here - the other way is productivity growth. This is something the UK has struggled with for the past 15 years - and there may be a silver bullet here in terms of increased productivity due to working from home. Note my use of the word “May”. Now there is structure and purpose and planning involved (rather than Boris just coming on the TV and announcing a lockdown), this should happen - but will it be a silver bullet or a damp squib? Alongside that, productivity is lowered when the labour market is very tight as it is at the moment anyway. There’s so much noise in the figures around this that generally, it is hard to put too much sway on them, but productivity has not yet reached pre-pandemic levels yet.

Remember as per last week - recession does not necessarily equal house prices going down in nominal (headline figure) terms, especially at the moment in times of 7%+ inflation. If they go up 5% this year and the inflation figure over the year is 9%, they’ve lost 4% in real terms which is a long way from the long-term average. I spoke last week of just how powerful low, fixed rate leverage is in such an environment.

So with that in mind, we circle back to windfalls. Firstly - what are they? My definition would be a disproportionate sum of capital, compared to one’s existing levels of capital and income, that comes under an individual’s control. There might be no mental preparation at all - for example a lottery win - there might be a period of preparing for the windfall (i.e. an inheritance, during the probate period) - or it might be a regular windfall if you are a trader in the city for example, knowing there will be a bonus of varying quality every year. It might be a cashing in of a pension lump sum which you’ve been looking forward to for many years - or the proceeds of a business sale.

Quite a wide range in all of that of course. As with many things in life, there is danger here that is inherent. Mindset is absolutely key - there will be differing sophistication levels in every case, and it might help to channel one of the best parts of “Rich Dad, Poor Dad” - today’s quote. Buy assets not liabilities.

Expectations are also absolutely key. What do you expect? I remember sitting with an investor in 2016 and what he wanted was to replicate the performance of his friends who had bought assets in Islington in 2011. There had been double digit capital growth in all of those years hence, including 23% in one year, in Islington. We looked it up there and then. I suggested a time machine was the appropriate tool for this investment - and made the case right there as to why I thought the London market was over its peak and in for a rough ride.?

My advice to him was to manage his own expectations compared to other investments available in the now. He went on to purchase some properties in an area I recommended to him, and the capital growth, whilst not Islington ‘11-’16 standard, has been solid and vastly outperformed Islington over the same timeframe (‘16 - ‘22).

We also need to make a very clear distinction between capital and income. Very often people have a capital sum to invest and that’s why they are reading or listening to this article, and just think “if only I could turn this ￡100k into ￡xxk per year income, for ever, I’d be set”. Harder than it sounds, of course.

There are some principles that need to be absolutely hammered home here. Don’t compare to investments in the past, as above. Compare to investments in the now. A second one is don’t use “bad news” as an excuse to procrastinate. Do the work. Find the deals. If you don’t have the time, find someone who does find the deals. Deploy. Time IN the market not TIMING the market - Uncle Warren, who makes a weekly appearance in the supplement of course.

Consider volatility. Return OF investment BEFORE return ON investment. Don’t chase 1% a month or 30% returns on loans from people who are bad credit risks, or who you wouldn’t trust with your grandmother, partner, or kids. Be realistic. How are they delivering those sorts of returns and leaving margins for themselves? Not impossible, but what’s their track record? What’s their reputational risk? What’s their skin in the game? Much easier to control your own destiny - just hard work…….you still control your destiny if you decide to lend money to shaky operators, I’m afraid.

What’s the best asset class for me? Well, I still believe leveraged property will outperform other major asset classes in the next 10 years. Otherwise I wouldn’t be in this space. That doesn’t mean don’t diversify - look at ISAs and lifetime ISAs if you are under 40 especially. The tax advantages plus the flexibility are excellent. But if your time horizon is under 5 years, don’t put the money in the stock market!

The single most important principle of all is one that is evergreen, windfalls or no - put the right people around you. This is the absolute key - it is a lonely game, we all need peers, and mentors, and don’t forget to put one hand behind you and help others on the way up either. That’s what others will have done to you, and pay it forward.

That’s it - the answer to the meaning of life in but a couple of thousand words. You are welcome. Well, perhaps it isn’t quite that much but it is a solid framework for dealing with a windfall, and an investment philosophy in general. Enjoy the long weekend……….