If you’ve missed some of the prior articles, basic guidelines on successful investing are in my book “Stairway to Wealth” available at LuLu.com.

Continued from Part 34Supply: Elastic vs Inelastic

There are two different kinds of supply. They are distinguished by how scarcity affects their prices. “Elastic” supply can be increased or decreased as a function of demand. People make a business out of the (elastic) supply and demand model, sometimes a very good business. A classic description of a generic business is the man who buys one piece of cloth for four pennies, tears it in half and sells each half for three pennies.

If demand is high, he’ll rip the cloth into three pieces. With decent volume, his kids can go to a costly pre-school in New York. But tearing cloth into ever-smaller pieces does not rise to the level of investment. Investments are different. Investments benefit greatly from a non-elastic supply.

It took a moment or two for Emily to get her arms around that concept. It helped when she remembered that time she fell asleep before a waiter returned with the appetizer.

Plymouth: No New Supply

Emily recalled only a little of what a date once told her over dinner. He was fascinated with the prices of old Plymouth Barracudas and often lectured her endlessly on their minutia. Having heard it before, she would tune out early in his lecture, and sometimes even drift off for a moment or two. He just rattled on and on and never seemed to notice. This particular evening he repeated things he told her on the last date, and even the date before. This was the time she dozed off, right at the table, even before the appetizers were served, so what follows is believed correct but not guaranteed. In any event, the details are unimportant. It’s the principle of how inelastic supply impacts value that bears watching.

In 1971 Plymouth built 16,159 Barracudas. Of these, 11 were convertibles with the hemi engine option. And of those 11, only two were ordered with a manual transmission. And only one of those still has all matching part numbers. That makes that particular “number matching” automobile one of the rarest of American muscle cars. As you would expect due to its scarcity, prices have been ratcheting upwards. In June, 2014, the car sold at the Mecum Auto Auction’s Seattle sale for $3,500,000 (including buyer’s premium).

Even at $3.5 million no company has been motivated to replicate the car because it can be copied but not duplicated. No copy would ever be an equally desirable substitute to the original. Among other obstacles, a contemporary model would not be a Plymouth because the Plymouth brand was discontinued in 2001. And it would not be built in 1971 because that year is gone forever.

This remarkably scarce vehicle was valuable due to its rarity and its inelastic supply. Rarity is not enough. There should also be a zero chance of increased supply.

Imagine another common, recent model car that could be painted a color never offered by the factory. Say, Nauseous Verde, a color available on demand at low-end paint shops. The supply of Nauseous Verde cars is elastic: any car could be painted that color. And any teenager with mommy’s credit card can have her car repainted. “Surprise! Last time you’ll ground me for coming home late!”

The principle here is that elasticity is mortal to rarity. The corollary is that even the threat of a small increase in supply can disrupt the existing market.

Diamonds: Always the Possibility . . .

For another illustration of how the variations of scarcity impact value, consider the “absolute scarcity” of Da Vinci’s painting Salvator Mundi, which sold in 2017 for $450,000,000, and contrast it with the “relative” scarcity of the 46 carat Graff Pink diamond, which changed hands in 2010 for $46,000,000. There is a reason the painting sold for ten times the Graff Pink: Salvator Mundi is unique, while collectable diamonds are only rare; they are not unique. It is almost inconceivable that another similar Da Vinci overpainting of Christ will ever be found, and partially because of this the painting sold for the middle nine figures. The confidence of permanent scarcity, Emily realized, is a value multiplier.

While there are no more Salvator Mundis and thus absolute scarcity applies to the painting, large diamonds are discovered reasonably frequently and auctioned more often than they are found. That is so because the world’s inventory of rare diamonds includes not only the unknown numbers in the ground, but also all those currently in private hands. Records show both newly found and pre-owned investment grade collectable diamonds (IGCDs) are available at auction at reasonable intervals. Examples are the 2016 sale of the Oppenheimer Blue, a fancy vivid blue 14.62 carats, for $57,500,000. It was the most expensive diamond ever sold at auction . . . until one year later when the Pink Star, a fancy vivid pink of (59.6 carats) sold for $83,000,000. With that history, it’s reasonable that buyers of IGCDs consider it is almost certain that other equally or even more desirable diamonds will be auctioned in the future. Nobody is sure quite when, of course. But because the known stock of IGCDs is small, each new discovery threatens to disrupt the value of all presently known comparable diamonds. It’s a supply risk and impacts values.  But Salvador Mundi is unique. And so is that 1971 Plymouth Barracuda.

 Consumables vs. Assets, Part I

Reputable economists explain that prices are established by the interplay of supply and demand. That definition is most useful when discussing consumables. In practical terms, it means that the providers of goods and services are driven by the prospect of extortionate profit, limited only by the market and its checks and balances due to changes in supply.

Whether the supplier is a farmer, a manufacturer, or an artisan, a high net profit will create competition and attract new suppliers. As profit goes up, total supply increases. If the demand side remains relatively unchanged, present demand will be satisfied by a larger number of suppliers. That, in turn, means the average supplier will book fewer sales. Per-supplier profits fall, and marginal producers find something else to do.

That’s the classic Chicago School of Economics approach, with its emphasis on rational expectations. It works best with consumables because barriers to entry are often lower. A farmer inDeafSmithCountycan sow more (or less) hard red winter wheat. The manufacturer can change the label so what dairy farmers used to buy by the bucket as udder salve suddenly becomes an expensive skin cream and marketed in tiny faux crystal jars at shocking prices. An artisan creates a stunning haute couture gown worn by some celebrity at an awards show. The celebrity is interviewed while standing on the red carpet and her outfit is seen by millions. Two weeks later there are Chinese copies of the dress at H&M for $14.99.

Whether wheat, or udder salve, or dresses that’s why supply and demand works best with consumables: low barriers to entry mean a nearly immediate market response.

Not so with assets.  Assets are different. Assets rise to the investable level only when they have barriers to entry. Supply and demand have less impact because values are largely driven not by supply but by scarcity. That is true of apartment buildings (there is no more beach front land), exotic cars (“I have something you don’t have and can never get, Winston!”), or stocks. If a company issued additional shares each time their stock rose to $100, who would be interested in buying their stock? Every time new shares are issued, existing owners would own less of the company. How do you get richer and richer by owning lesser and lesser?

 Disproportionality

Hypothetically, imagine yourself in a coin-flipping contest. For every head you toss, you get $1 from the other guy. Every time the coin lands tails up, you must pay $1. There is no vigorish. Nobody knows what will happen over the short run – you could flip an unlikely number of consecutive tails – but if the timeline is long enough, the heads will eventually equal the tails. The outcomes in this example are proportionate. They are 50/50. Over the long term, the very best a player can do is to break even. That’s not what an investor seeks.

An investor looks for disproportionality. An example of a disproportionate conclusion would be, in the coin flipping example above, if you got $2 for every head you tossed, but only had to pay $1 for each tail. Clearly, the offer of such a disproportionate trade would constitute a “Here, hold my beer” economic moment. “You’d give me $2 for each head and I’d only have to give you $1 for each tail? Really?

Disproportionality is reasonably judged against available options. When the outcome of an investment is disproportionate, at least one party to the trade thinks he received more total benefits (present or future or both) than anybody else would pay for that property at that time.

But in the best trades, both parties get something they want that they didn’t have before.  They can be totally different things. For example, in the BNSF railroad case we’ve talked about, Buffett gained an irreplaceable quasi-monopoly in exchange for paying more money than anybody else would or perhaps, could. In the minds of the selling stockholders, they won. They got more money than they thought possible.

Buffett, in his mind, won bigly. He received an increasing stream of secure, compoundable income for as long as the grass grows and the rivers flow.

While not required, it is often the case that both parties benefit comparably from disproportionality. The buyer may leverage the purchase of an apartment building (example: buying a $3 million dollar apartment building with $1 million down payment and a loan of $2 million). When the tenants pay off the loan the buyer will have tripled his money just in equity build-up. More benefits accrue in the form of appreciation, depreciation and cash flow. On the other side of that same transaction, the seller received $3 million cash to buy a $9 million building. The parties benefit disproportionately, but both are satisfied. The sellers would rather have the money than their present asset. The buyers would rather have the asset than their present money.

Assets that rise to investment quality feature long term disproportionality for the buyer. Supply is limited because there are barriers to entry that restrict or cap new supply sources, but demand continues to compound over time. The Burlington Northern Santa Fe railroad and MidAmerican Energy are both quasi-monopoly businesses that have huge barriers to new competition, and whose net incomes can reasonably be expected to compound for generations.

 Consumables vs. Assets, Part 2

Businesses

Generally because of low barriers to entry consumables tend to be price sensitive. Commodities are a type of consumable that competes only on price. Everything else being the same, given identical packages of uncooked spaghetti from different producers, the cheaper purchase will sell more and quicker.

But some things do not compete on price alone. That’s what makes the asset a candidate for investment: there is demand combined with barriers to entry.

Barriers to entry come in several classes:

  • Intangibles (brand, patents, copyrights, etc.).
  • Economies of scale (Amazon, Costco)
  • Switching costs (banks, medical devices)
  • Network effects (Microsoft, Facebook)
  • Legal, environmental, economic restrictions (garbage dumps, utilities).

 Apartments

An apartment owner who does not wish to compete on price alone might choose to keep the above list of classes, but modify their contents in the following way:

  • Intangibles (school system, view, proximity to houses of worship)
  • Economies of scale (ownership of multiple units/buildings in same area)
  • Switching costs (three-bedroom units in a good school district)
  • Network effects (WalkScore, employment, public transportation)
  • Legal, environmental (restrictions on further development)

 Degrees of Scarcity

Things might work out better if any new apartment purchase had at least some of the features mentioned above. Even one item, however, is sometimes enough to improve the investment. As an example, would a three bedroom apartment likely earn a higher rent in a good school system or a poor system? Would a young single person likely pay a higher rent for a unit with a good WalkScore in a high employment node or for some isolated unit hours away from employment? The questions answer themselves.

Many tenants willingly pay for useful amenities, even the ones not onsite. A good school system is outside the apartment owner’s control, but the landlord nonetheless benefits: a fructiferous young mother will pay higher rent to receive better educational benefits for her children. Combine good schools with three-bedroom units and multiple local employment centers and the apartment becomes uber-desirable to more tenants.

Owning apartments is not a charitable work, or at least it shouldn’t be. In place of or in addition to higher rents, the practical benefits of the various barriers to entry could take different forms: (a) fewer vacancies; (b) quicker re-lease; (c) higher tenant quality; (d) quicker sale, or  (e) lower cap rate (no free lunch: this is a sadness when purchasing, a boon when refinancing or selling).

 Executive Summary

  • Popular economists explain that prices are established by the interplay of supply and demand. That definition is most useful when discussing consumables due to their elastic supply.
  • Assets are priced differently than consumables. Asset prices are largely driven not by supply but by scarcity.
  • Investors benefit from disproportionality. When the outcome of an investment is disproportionate, one party to the trade receives more than he paid. Somewhere in the deal there are benefits not included in the price.
  • A scarce item, if it’s desirable enough, does not have to compete on price alone due to barriers to entry for new competition.

This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional.

Klarise Yahya is a Commercial Mortgage Broker specializing in difficult-to-place mortgages for any kind of property. If you are thinking of refinancing or purchasing real estate, Klarise Yahya can help Commercial Mortgage Broker, BRE: 00957107  MLO: 249261. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email Info@KlariseYahya.com.