Investing

When most people hear the word depreciation they normally think of an accounting term vaguely linked to taxes.  While this impression isn’t untrue, the word depreciation has a much greater meaning to investors in tangible assets.  Depreciation is simply the gradual and inevitable erosion of value that happens as a physical item wears out over time.  This primarily occurs in two ways: first through exposure to the elements and second via mechanical wear.  But in either case, depreciation is the mortal enemy of any tangible asset investor.

Houses, boats and cars are all examples of tangible assets that slowly bleed value through depreciation unless money is constantly pumped into them.  A house, for example, can give the illusion of gaining in value every year.  But this ignores the fact that a homeowner has to inject a substantial amount of money into the structure on an ongoing basis to keep it intact.  This usually amounts to somewhere between 1 and 2 percent of its market value per annum.  Of course, this amount will vary from house to house.  A stone house, all else being equal, will depreciate a bit more slowly than a wooden house due to stone’s higher durability.  But even a stone house will eventually decay into a pile of rubble if repairs aren’t made on a regular basis.

The same concept applies to boats where an old adage recognizes the power of depreciation.  As the time-honored saying goes, a boat is a hole in the water that the owner keeps throwing money into.  If you don’t consistently maintain a boat it will eventually deteriorate to the point where it ends up at the bottom of the harbor.  Even very fine and expensive yachts are subject to depreciation.  In fact, the larger and pricier the boat the greater the dollar amount of yearly depreciation.

Cars aren’t any different.  That 1960’s muscle car might look amazing, but every additional mile that is placed on the odometer lowers the value just a little bit more.  It is possible to avoid much of this depreciation if you’re willing to drain the vehicle’s fluids, remove its wheels, put it up on blocks in a garage and never drive it again.  But even then the rubber hoses and other soft parts of the car will slowly turn to dust over time.  And we’ve ignored the fact that the garage the pampered car sits in will itself slowly depreciate over the years as it sacrifices itself to the elements in order to preserve the prize vehicle.

All this talk of depreciation might sound depressing to someone who wants to invest in tangibles, but there is no need for despair.  There are a variety of tangible assets that have either no or only minimal depreciation.  Vintage fountain pens, mechanical pocket watches or wristwatches, estate jewelry, ancient or medieval coins, European art medals, antique silverware, objets d’art and medieval illuminated manuscripts are just some examples of tangible assets that experience almost no depreciation.  And the storage requirements for these tangible assets are usually modest, requiring only a climate controlled space, like the living area of a house.  With a minimum of care, these works of art will survive and appreciate for decades, if not centuries, to come.

Astute investors will have a rare window of opportunity to accumulate tangible assets cheaply over the next decade or so.  And this is likely to be the last good chance for a very, very long time to come indeed.  Many years from now, when we reflect on how ridiculously cheap rough jade or medieval illuminated manuscripts or Edo era Japanese netsuke were circa 2015, we will wonder why we didn’t buy more.  This is one of the great ironies of human nature as applied to investing.  People don’t feel compelled to buy great assets when they are inexpensive.  Instead they wait until after an asset’s value has been widely recognized by society and its price has already ascended to the heavens.

Over the coming years, the U.S. dollar will rise significantly against almost every other currency on the planet.  There is a simple, but poorly understood reason for this prediction.  Fiat currencies derive their strength from two key sources.  One is the government’s acceptance of money in receipt of tax liabilities.  So when an individual or company generates income, a portion needs to be retained and remitting to the government in the form of the prevailing legal tender.  This creates a sustained demand for the national currency unit in question.

The second major source of demand for a fiat currency is debt service.  Money is constantly in demand to satisfy the principal and interest payments on existing debts such as mortgages, car loans, corporate bonds and bank loans, among others.  This is the larger of the two sources of demand for the U.S. dollar.  According to the Federal Reserve Bank’s Flow of Funds (Z.1) report, U.S. dollar denominated debt outstanding as of Q3 2015 totaled over $44 trillion dollars.  This almost unimaginably large sum of debt voraciously consumes dollars like a money vortex that is never satisfied.

Debt in U.S. dollars actually denotes an outright short position in that currency unit.  When an investor shorts an asset (including currency) he does so with the hope it will decline in value in the future.  But over the coming years the opposite is almost certain to happen to the U.S. dollar.  This is because too many people owe too many dollars on outstanding loans.  This is the equivalent of a massive short position in the U.S. dollar.  This will likely trigger an event called a “short squeeze” during the next period of financial uncertainty, prompting everybody to frantically exit their short positions simultaneously.  In this case, people will try to pay back all their dollar-denominated debts at the same time.  This situation will cause the international exchange value of the dollar to skyrocket as everyone – consumers, businesses and financial institutions – scrounges madly for dollars in a desperate attempt to retire their outstanding loans.

But won’t the Federal Reserve just print more dollars to offset this sudden demand?  Well, yes, I certainly believe they will try.  In fact, I fully expect the Federal Reserve to engage in substantial additional quantitative easing (QE) by printing money to buy government bonds, mortgage securities, corporate bonds and even stocks!  However, central banks worldwide have had a poor track record of satisfying the sudden, overwhelming demand for their national currencies in times of crisis via this method.  The Bank of Japan, in particular, is a poster child for the futility of this strategy.

So the dollar will inevitably rise in the coming years.  But there is an intriguing corollary to this scenario.  As the U.S. dollar rises in value, tangible assets of all kinds will become (temporarily) cheaper.  We’re already seeing this in the commodities market, where gold, for example, has lost over a third of its value in last few years.  Art and antiques will most likely experience a similar scenario as the dollar strengthens and over-indebted individuals are forced to sell assets at fire-sale prices.

At this point you may well question why one should invest in tangibles if prices might decline in the near term.  The answer is straightforward; in finance nothing goes up (or down) forever.  While a strong dollar is more or less a foregone conclusion over the coming years, it really represents your best, and perhaps last, chance to build a discriminating collection of fine art or antiques cheaply.  Eventually, after a monumental struggle, I expect that the Federal Reserve will succeed in its misguided effort to debase the U.S. dollar.  I would much rather be holding high quality, investment-grade tangible assets when that time finally arrives rather than stocks or bonds.

Benjamin Graham was one of the most famous and intellectually important investors of the 20th century.  He is sometimes known as the “Father of Value Investing” for his groundbreaking research in the field of equity investing during the 1930s and 1940s.  His two most famous books – Security Analysis and The Intelligent Investor – are considered classics.  They are still read today by those looking for greater insight into his seminal style of investing.  One of the key themes that Benjamin Graham propounded was the idea of margin of safety when investing.

Margin of safety can be defined as only buying a stock at an appropriate discount to its intrinsic value.  The intrinsic value of a stock is usually characterized as its tangible book value – the value of all the real assets of the underlying company like cash, property and salable inventory minus its liabilities.  This calculation explicitly excludes goodwill, patents, trademarks and other potentially valuable intangible assets that a company might own.  The fundamental idea behind margin of safety investing is that the risk of future loss is greatly reduced if an investor only buys a company’s stock when it trades below intrinsic value.

This Grahamian concept of margin of safety has been a mainstay of value investors in the securities markets for decades.  However, the idea can also be adapted for use in the fine antiques market as well.  Many investment grade antiques are made from precious metals or gemstones, giving them an intrinsic value component.  The intrinsic value of precious materials in antiques can be considered equivalent to the tangible book value of publicly traded companies.

In other words, intrinsic value effectively puts a floor underneath the market value of a fine antique in the same way that it does in a stock.  As an added bonus, high intrinsic value also tends to enhance the desirability and therefore the collector’s premium applied to investment grade antiques.

Now, there are some subtle differences when applying margin of safety in stocks versus investment grade antiques.  First, while uncommon, equities do occasionally trade below their intrinsic value.  Antiques, in contrast, very rarely do; specimens that sell for less than their intrinsic value are quickly snapped up in the marketplace.  Instead, investment grade antiques usually trade at a premium (sometimes a large premium) to their underlying intrinsic value.  This premium is attributable to the artistic, historical or collector’s value of the item.

However, the fact that investment grade antiques rarely sell below their intrinsic value doesn’t invalidate the core concept of the Grahamian margin of safety.  To the contrary, intrinsic value tends to create a hard floor under an antique’s purchase price.  So, for example, an engine-turned, Art Deco era, sterling silver cigarette case may sell for $150, but have an intrinsic value – the bullion value of its sterling silver – of $80.  This means the artistic or collector’s premium you’re paying is $70.

In this hypothetical situation, the intrinsic bullion value of our chosen objet d’art would effectively limit your potential loss to about 47% in a worst case scenario.  No one intentionally buys an investment grade antique expecting it to drop in value, but in the unlikely event it does, the item’s intrinsic value prevents your loss from being excessively severe.

Now the margin of safety idea cannot be universally applied to any work of art.  For example, it usually cannot be utilized with the major arts, like paintings and sculpture.  Paintings are made from canvas and paints and therefore have no intrinsic value.  Likewise, sculptures are usually created from stone or bronze which also have either no, or minimal intrinsic value.

When you purchase a work of major art, you’re exclusively purchasing artistic premium.  This can either be very good, or very bad, depending on future price movements.  In any case, you can’t rely on margin of safety to reduce risk in these situations.

Using the Grahamian concept of margin of safety to limit risk is a godsend to risk-averse investors who wish to allocate a portion of their portfolio to investment grade antiques.  It allows you to boldly invest in a largely unexplored, but high-return-potential asset class while simultaneously mitigating the possibility of severe loss.  Margin of safety has worked for stock investors for decades and there is no reason it can’t work for savvy antique investors as well.