Which SIPP Investment: 6 Vital Questions (2 of 6)

Question 2: Do You Understand Your Potential Investment Thoroughly, Or Are You Willing To Learn?

If you do not understand an investment, do not do it

This is simple advice, but it is notoriously hard to follow. Many self-directed investors get wrapped up in someone else’s dream: a start-up polymer plant, a new restaurant in Tokyo, energy from tidal waves, a “super” trading strategy. There is a part of all of us that wants to be part of something bigger, something important. Sometimes, an idea can seem more alluring because it is mysterious or exotic. That does not always bode well for an investment. You have to strip away the mystery and the inspiration to facts you can confirm. You would not give someone else money to invest in things that they do not understand, so do not give money to yourself to invest unless you understand the investment completely.

This issue of understanding the investment is so pivotal to the success of your investments that I discuss this question at greater length than any of the other questions in this article.

Understanding should be detailed. Take the restaurant in Tokyo. I know what a restaurant is. I not only know where Tokyo is on the map, but I did business there for years. That does not count as knowledge and understanding, at least not for me for a restaurant business. My trips to Tokyo had nothing to do with investing in restaurants. I know little about running a restaurant, and nothing about how to analyse the potential traffic that the restaurant might have. This is true for restaurants anywhere, let alone in Tokyo. After all, the important point for a restaurant is the traffic, not just liking the menu.

I know what I don’t know.

I know that I do not understand what makes a successful restaurant in Japan. Furthermore, I know that I could lose a lot of time trying to learn this. By knowing what I do not know, I can quickly pass on a restaurant in foreign countries. Even if it were not a new restaurant, but an existing one with a track record of revenue and profit, I would still pass. I am in no position to understand how the past might change from the future for restaurants in Tokyo.

I suggest you get good at knowing your own limitations. Know what you don’t know.

I do know that restaurants have a horrible survival rate. This also allows me to pass early. This helps me to know that I do not want to spend valuable time learning about such potentials.

This particular piece of advice, to know your investment exceptionally well, leads many people to invest in real estate, for example a rental property. After all, we all live somewhere and have probably paid rent at some time, or at least understand the concept. Real estate represents one class of investments that many people feel comfortable with. More importantly, they have real experience with it. The on-going risks (such as potential damage or vacancy) seem clear. How to manage them seem clear as well. Potential damage can be covered by insurance and proper rental clauses. Vacancy represents a major risk factor for rental property. You may be able to manage it through your offered price (lowering it) or you may be subject to a down market. Even if you cannot completely avoid a risk, you can understand it. There are further risks associated with buying which most estate agents can guide you through.

By the way, notice that I advocate using expert advice. I will come back to this in Question 6.

To understand an investment, you should be able to make a small financial model of the company’s profit, either on paper or better in an excel spread sheet if you have those skills. What are the sources of revenue (e.g. rental income, or feed-in-tariffs from the electrical grid)? What could decrease those revenues (e.g. vacancy or lower rental prices for property, or change in feed-in-tariffs for solar energy, or the number of patrons and cost per person for a restaurant, etc.)? What expenses are there? What might make them get too large?

To get different dimensions on revenue and expense, you could ask various questions: What assets are crucial to this revenue (e.g. the house, or the solar panel)? This might lead you to the necessity of insurance on these. What on-going expenses reduce this revenue and how do they potentially change (e.g. maintenance fees, taxes, insurance, inspections, legal fees, etc.). Even a simple estimate of all that goes into making the final profit will greatly help you to understand the entire project and its risks.

At the early stage of understanding an investment, it is ok to use figures given from anyone you are talking to. Later you will check any facts during due diligence (Question 5). Initially, you just need to get a model of the investment in your head (or in Excel).

Use the small financial model as an indicator of how to buy the investment, how to manage it, and if necessary, how to sell it. Let me give an example.

I once invested in a kitty litter plant in Hungary. Through my advising work, I came to know and trust a chemist in Budapest. He had developed a substance that is essentially a great sponge. It was used in Lake Balaton in Hungary to suppress the mosquito population. They essentially would dump these tiny absorbing pebbles in the mosquitos’ breeding ground to dry it up during the right time of the mosquitos’ life cycle to prevent the next generation. It was totally environmentally safe. As it turns out, the dumping was done by helicopter. The crucial development for this project was to make the substance as light as possible.

What does this have to do with kitty litter? The idea was that this substance also makes a great kitty litter. It is very absorbent. Since it is so light, the average housewife can easily carry a few bags. It seemed a clever innovation.

The thing about this project was that it was a great idea. However, the chemist knew nothing about marketing, distribution, or mass production or … well, anything other than chemical research. It was necessary to have these things done by someone else. That someone else was not me. I knew nothing of those things either. What is more, I know so little about these things that I was in no position to judge who is good at those things in order to put a proper team together.

This honest assessment helped to structure the entire project. We would make a prototype machine to produce the kitty litter and then sell the idea, the intellectual property and the right to use the formula, on to another investor. We did know a mechanical engineer able to build a small prototype. When calculating revenue, I put zero for periodic revenue and figured my entire profit would come from selling on the idea. This helped to focus the initial cost limitations. We spent nothing on starting up the marketing or finding a factory site. And so forth. I made money on this deal. It was not what I had hoped, but I knew at the beginning that it was difficult to value the ending profit. In the end, I was satisfied with the amount I made. Knowing all the risk factors guided me to focus on just the prototype finding the next investor, and nothing more. I was able to accept the final return when a buyer of the company did materialise because I had prepared myself that this is the only good way that I can manage this asset, by getting it into the right hands of someone that can take it forward past the prototype. If I had tried to hold on for more profit, I would probably have lost my entire investment.

Understanding risks does not always mean that you will lead to a sure-fire investment, not one that makes you filthy rich. What it will do is to give you proper perspective for making investment decisions.

Notice that my “back of the envelope” financial of this model was quite easy. Profit equals final sale price minus initial investment to make a prototype minus incidental expenses (e.g. gas). My time commitment was just a few days. The risks were that prototype expenses would get too large and the final sales price would be too low. This guided my decision making. The man building the prototype was clever and always finding innovations that would help in production. Rather than building these (which would increase my investment), we documented them (which only cost a little time). By documenting them, we were increasing the sales value, the intellectual property. These ideas were encouraged. Rather than increasing investment cost, they increase final sales price.

Here are some basic questions I ask to get a quick understanding of whether or not a project is worth looking into deeper.

A. Is it a project or a business?

Putting a solar panel on the top of your house (or someone else’s) is a project. Selling solar panels to homeowners to put on their house is a business. The first has no real potential for growth. Electricity prices might increase, but that is not a growth business, just one with an inflation adjustment. However, selling solar panels is a growth business, and we can expect (or more correctly hope for) higher sales as time goes by. Sales growth can be managed. The business valuation can grow. Eventually we can sell on the business or it will start generating profits like a cash cow.

Typically, a project’s profits come only from its cash flows, not from later sales. A business, on the other hand, might have a strong portion of the expected profit come from selling on the business.

This is not always the case for every business, of course. You have to know what your investment might pay, when it might get sold (if at all) and for what price.

Investing in a rental property is a project. Investing in several is a portfolio of projects. At some point you may start reinvesting profits into more properties. Arguably, at this point, the portfolio becomes a business.

The difference is that with a business, there is a transaction that can be replicated. There is at least the potential that eventually profits will fund future transactions and future profits. When this happens, the business becomes a “cash cow,” simply throwing off profits. The cash cow stage is only a true cash cow when you do not need to spend any time running the business, or only nominal amounts of time. A project on the other hand, is a limited thing with no chance or intent to be replicated.

This distinction between business and project is not black and white. One real estate investment might be a project for me since I would only do one or two of them. I have no intent to continue forward. In another person’s hands, this same type of transaction could be the start of a real business since they can replicate it and go forward with it, aiming for the cash cow stage.

Thinking of an investment as either a business or project will help to crystalize other questions. For example: are marketing and sales important to this investment? (“No” for projects, “crucial” for a business)

B. If the investment is a business, who is your target market and how do you position your product/company to them?

How well does the business manager know the market? What do you know about the market? Is the product a luxury item or does it solve a problem?

For example, is your rental property targeting a niche type of renter in the hopes of getting higher returns? Or are you targeting a more standard renter, in which case your returns are unlikely to be much different from the remainder of the market.

If the business you wish to invest in is selling solar panels, do you target a certain group, for example those who can get a grant to pay for your product? Is helping with the grant process part of your sales pitch and value added for the end client?

Is the business selling high end watches or individual fitness coaching? Is the true value vanity? This could pay for exceptional prices. In such a case you would have to understand how targeted customers are found and sold to.

With a business, you must have a clear view of the end customer and how you add value for them. Is the product a mainstream product (with average returns) or a luxury product (with potentially higher returns)?

Are your sales and marketing teams up to this task? Do they have a track record?

C. Is this investment following the market or innovating?

Is this idea untried, or does it have a successful track record?

Solar power may have successful track records but tidal wave production does not. Most technology ideas are new and have no track record. They are untried. Even if the technology is tried and true technology, is the delivery process tested? Has the proposed team done similar things before?

Renting out property is not a new idea. The way it is done could be. However, some real estate ideas might revolve around niche renters, or special refurbishment ideas. Innovative methods may be a gold mine, or they might not.

D. What is the exceptional story?

Is it a new technology, or a new niche market? It is rare that an exceptional investment does not have a clear and good story. Even property that is a bargain usually is being sold quickly for a reason. It is good to find this out. Convince yourself that there is a good reason that you can expect exceptional returns, or more guaranteed returns.

E. Why now?

Is timing critical on this investment? If so, why? If not, why would a good deal wait?

F. What is the return, and what does it rely on?

This is where you develop a little model of how the investment works, either in a spread sheet or on paper, whatever suits you best.

Deal Structure: Equity, debt or a combination? Do you get a piece of growth of a business, or just a return? Are there any chances (i.e. contract clauses) for equity to become debt or vice versa? Are you buying a special portion of the business, such as the intellectual property of something, or perhaps just the rent on the facility?

Where does the revenue come from? What expenses are necessary to get that revenue? Do expenses come first (marketing/sales, refurbishments) or after (maintenance fees, building the widget, etc.)

Risk Factors: What could affect the net profit (e.g. sales, exchange rates, longer construction times than planned, damage, key person issues, etc.)?

Is the investment currently yielding a profit or only projected to do so? Either way, what comparable companies or projects are there and what was their result?

Will profit come from continued cash flow (rental income, dividends from the company) of from an “exit” such as selling the project/business (e.g. “flipping” a property, selling the business on)? If an “exit” is a significant portion of the return, what are comparable prices for their assumed exit price?

If there are statements about growth, what are these based on?

G. What are comparable projects/businesses and how did they do?

In addition to the obvious idea of finding unrelated businesses and reading their story, also think of related businesses. Is the investment one to “turn around” a business that has not gone as well as it should have? Why will the future be different form the past?

I am generally sceptical about turn-around situations, especially if the same management is in charge. Often a company might bring in a new star executive, a new marketer, or new Chief Operating Officer, and represent this as fundamental change. In my experience, most companies needing a turn-around have bigger problems than can be fixed by a single person, no matter what position he or she might be taking.

So, when checking comparable companies, start with the company itself. Or if the company is a start-up, check the companies that the management most recently worked at. (This is covered in more detail below.)

H. What will investment funds be used for?

Will they be used for construction, purchase, buying out or buying in management?

If someone is being bought out in order to exit the business, ask why. It is not bad if the current owner is selling. Just try to understand why. It might be that they are fed up, or it might be that they are retiring. It could be that they were a good owner for one stage of the business, but the next phase requires a different player. (Remember my kitty litter factory?) Alternatively, if the people close to the company are leaving with no good reason, maybe before a time of huge forecasted growth, it is good to connect those dots and ask yourself why. If the business is so good, why are key people leaving?

If the funds are used to expand the business or refurbish property, ask specific questions about how the money will be spent and why the people spending it are the best to make such decisions.

I. Why are you being asked to be an investor?

If you are being promised an exceptional return for your investment, why is the company unable to raise funds through other channels, other channels that might charge less than you are being promised?

J. Who will bring the idea to fruition and what is their track record?

A researcher may know nothing about bringing a product to market or producing things in a production line. An estate agent may know nothing of refurbishments. I know little of restaurants.

For each of the critical risk factors of the business, who will be doing that portion or managing it? Is that someone new to the area or experienced? Are you in a position to judge?

Are you participating in the project? What is your experience in this area? Would you hire you to do it?

K. Will this business require later investment, by you or someone else?

If so, what is an honest assessment that the company can get more funds at a later stage?

Some business plans only work if there is more cash down the line. The potential to sell on the business at a profit is different from the situation where a business MUST have more cash later.

For example, some construction projects require cash after construction. One example is a project to build a new block of condominiums. The builder needs financing to build the property. Then the buyers typically need financing to buy the property form the builder. In the normal course of things, common people can get financing to buy homes. However, recently we have seen the conditions for mortgages have gotten worse and many people are having difficulty to afford homes, even with mortgages. To invest in a construction project, you must understand the potential for the buyer to be able to finance. This requires an insight into the economy around the time that construction ends. The potential for there to be buyers counts as a crucial risk factor for such a project.

Many movies require financing in stages. First the script must be written. Then, there will be the filming. Then the film must be taken around to film festivals to get acceptance and hopefully acclaim, and eventually there must be a marketing budget for the film. Each of those generally requires a different investment. The first might be only an investment of time by someone, and typically is, but all the others require cash. If you are investing in film, do you understand the potential for investment at each point along the film’s life cycle?

It is fair to ask why all the necessary investment is not being asked for at one time. The answer is usually that the later investments want to see more of the project finished. This means the earlier investments are taking more risk. The earlier investors should have more favourable terms. What is the plan for inviting in later investors? Perhaps you might like a later stage better. If there are later stage investors that will not come in early (when you are being asked to come in), do you understand all the risks that they are trying to avoid?

L. What is the cash flow and length of the project?

Does this fit in with your overall pension strategy?

If you have decided to do your own investing, then the responsibility is on you.

If you do not understand the investment, then no one does, at least not anyone with only your interests at heart.

Question 3: How much of your time does this investment require?

which sipp investment
Dr Matt Modisett

About Dr Matt Modisett

With more than 25 years’ experience, Dr Matt Modisett PhD FIA ASA MMA has spent his career in investments and insurance.  He's worked in the USA, Japan, The Netherlands, Spain, Belgium, Hungary, Australia, and the UK. He was formerly a Chief Investment Officer for an insurer, Asset-Liability Manager for three insurers, and has consulted for many years, all for top tier institutions. He has served as Professor of Actuarial Science and also as Professor of Finance.

He holds a PhD in Mathematics, is a Fellow of both the UK Institute and Faculty of Actuaries and the Hungarian Society of Actuaries, and is also an Associate of the USA Society of Actuaries. He has numerous publications to his credit.

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