I talk with other investors on a daily basis. Investors love profit but hate risk. A common question I am hearing a lot these days is "are we at the bottom or is there more downside?" My honest answer is I really do not know... I will tell you there are many stocks, bonds and real estate deals that are being sold for far less than their replacement cost. One example is a pipeline stock that I personally own that is being traded for $2.65 yet has a book value of $16 and a replacement cost of about $30 per share. I have gone out on a limb and purchased more of this company because I believe it will recover and I see little downside risk at this price.
Another example is homes are being sold for $30-$50 thousand about 30 minutes north of where I live. These homes cost at least $100 thousand to build even with today's reduced raw material costs. Could both still go down in price? You bet (no pun intended).
I was talking with an investment group out of Texas a while ago and they wanted to know about downside risk. The investor's actual question was "do you think there is more than a 20% downside?". The vanilla answer is I do not know. However, I personally think prices will not dip much lower. Then I had an idea. What if two investment groups got together where one group provided 80% of the purchase money and another group provided remaining 20%. The group that put up the 20% would take the first hit in any realized loss of value. In exchange for this risk, the 20% group would receive 60% of the any profit realized. The group that put up 80% of the money now has a hedge against losing money and yet they still have the opportunity to make a very good return on their investment.
If you are confused, let me give you an example to explain my idea. Say we have an office building that appears to have an asking price half of the replacement cost. So the asking price is $1,000,000 and my two imaginary investment groups put up their 80/20 ratio of funds. Assume our investment time horizon is 5 years. At the end of 5 years the two groups agree to put the building on the market for $2,000,000 (its replacement cost). The group that put up $800 thousand would get 40% of the $1 million profit and the group that put up $200 thousand would get 60% of the profit. The group that wanted a partner to absorb 20% of the risk still has a 50% profit ($400k/$800k) or an average of 10% profit per year. The group that essentially acted as the risk absorber was able to make a 300% profit ($600k/$200k). This idea provides risk mitigation, at a price, to those that want to invest but are worried about losing more money. The risk taker is only at risk for the initial investment and has the potential to earn handsome returns.
I know financial engineering got the world into this mess BUT how are suppose to get out of this mess without financial engineering? Just because a bridge collapses does that mean we should never engineer and build another bridge? We must analyze why the first bridge (or economic model) failed and then avoid the same mistake. The financial meltdown last fall was the result of bets in the market by insurance companies and Wall Street institutions that risked more money than they had. That was a big mistake. My idea is does not call for such outlandish risk taking. My idea rewards those that have an appetite for risk and eases the mind of wary investors that are concerned the market has not reached bottom. If you would like to be a risk mitigator (i.e. the investor that puts up the first 20% at risk), please give me a call and I can point you to investments where 80% of the money is waiting for someone to take some of the risk.