The Market is Smarter Than You

Was there really a connection between Saddam Hussein and Al Qaeda?

Though I have my doubts, I'm certainly not in a position to be definitive with an answer. However, This book, by Stephen F. Hayes of the Weekly Standard, argues that there was.

Given the book's premise, the polarized 1-star/5-star reviews on its Amazon page are hardly surprising, and, I would argue, don't really provide much information about book's content. There is, however, a ready guide available for understanding its real value--one that I've touched on in another context before--its used price: 1 cent.

This ranks The Connection alongside such classics as Bankruptcy, 1995, and Unfit For Command.

Viva la Price System!

Publish or Profit?

Whenever someone tells you that he or she knows how to beat the market consistently, please feel free to raise an incredulous eyebrow. When that person follows up such a claim with an offer to show you how to do it... for a fee, make sure you've still got your wallet as you move a safe distance away.

The reason why is a concept I have touched on before: competitive markets are very efficient at driving down "abnormal" profits.

The Unknown Professor agrees with me on this, and in this post he points out an interesting recent paper that is yet more evidence for the validity of the efficient markets hypothesis.

Colby Wright, the paper's author, wondered why a financial economics researcher who thinks he's found a legitimate exploitable anomaly would tell anyone about his discovery instead of simply keeping the information to himself and taking full advantage of the profit opportunity. Wright hypothesized that researchers without established track records and with fewer published papers would be more likely to write about market anomalies than those researchers with strong reputations and long publishing careers, because writing about an anomaly would help a newer researcher establish their reputation (and the veteran researcher would rather keep the opportunity to himself). The evidence, according to Wright, bears this out.

For more detail, see the post at Financial Rounds, or read the original paper.

John Burley's ROI Redux

John Burley makes a point to frequently tout the “Level 5 Active Investor” rates of return he and his successful students get on their “investments”—and how you can do it, too, once you’ve learned the “secrets.” I’m sure Burley, being the consummate slick sales guy, recognizes that, along with the promise of “financial freedom,” his claim that his “cash flow” technique consistently provides “20-100%+ returns” is his most alluring siren song.

I have grappled with Burley’s return on investment (ROI) claims from a more theoretical perspective in prior posts. I’m fairly confident that my analyses were persuasive and comprehensive. However, Burleyists could still use my focus on the abstract to their rhetorical advantage, saying, “Psychobabble! Einzige’s theories are all well and good, but the real-world success of John Burley and his students clearly refutes them.” If you go by what Burley and his students tell you then, yes, they might have a point. But you’re not going to get the whole story by going through Burley’s promotional materials, reading the mastermind forums, watching the videos from Progressive Profits, or, I suspect, even attending Burley’s expensive weeklong Boot Camp. Something tells me that Burley isn’t likely to be making his tax records available any time soon, either. What we’re left to work with, then, isn’t much more than theory and conjecture.

On the other hand, there is one thing we do have: the public record. We can use that, plus some theory and educated guessing, I believe, to shed more light on an area that Burley would undoubtedly prefer stayed shrouded in darkness.

Burley himself provides us with an excellent starting point on pages 379 to 388 of his book, where, in the process of going over his “cash flow strategy,” he gives concrete examples of actual properties his company has managed over the years. Burley stresses to his readers that the homes he highlights were “not special deals… I selected these for illustration because they are very typical…” Fortunately for us, he gives just enough information about each property to make the relevant documents easy to find in the online database of the Maricopa County Recorders Office.

Here is one of his examples:

3320 W San Miguel

I acquired this property in May 1998. It is a typical ‘Lunch Pail Joe’ house. Built in 1958, it is a 110 square meter, 3-bedroom, 2-bathroom house. It had a swimming pool which required replastering (responsibility of the new buyer). The inside and exterior had just been painted by the lender.

It was a lender foreclosed property. The purchase price was $58,513 with monthly payments of $431 (PITI). I took out a 90% loan at 7.2%. My deposit plus settlement costs came to $7,549.

I remarketed the property 16 days later for $74,900 with monthly payments of $756. I collected a deposit of $3656. This gave me a contract profit of $16,387 and a monthly profit $324; 30 years at $324 a month equals $116,740 of passive (positive) Cash Flow.

Let’s take a look at the first year cash-on-cash return on this property. We do this by dividing our initial investment capital into the first year’s income. The initial investment capital was $7549 divided into $3,656 deposit plus $3,891 received as 12 monthly payments of $324 from the new buyer. This is $7,549 divided by $7,547 = 99% [sic] first year cash-on-cash return.

Follow the links to the recorded documents I’ve provided in the above quote and you’ll find that the public record bears out Burley’s dates and dollar figures. However, in detailing this example, Burley has engaged in significant distortions and withheld pertinent information. In no particular order, these include:

Investor Property

If you’ve looked at the linked documents, you’ve probably noticed that Burley didn’t really own this house. It was actually owned by one of Burley’s investor partners, John McCants. As Burley’s partner, it’s McCants’ job to put his name on all the paperwork, as well as put up all the front money and make the underlying mortgage payments. He then splits the profits with Burley 50-50. So, McCants supposedly gets, at best, an (admittedly not unimpressive) ROI of 45%, while, in effect, paying Burley an exorbitant 50% glorified property management fee. Of course, McCants also takes 100% of the hit when the buyer isn’t making payments, or when the property is sitting vacant—and that’s going to eat away at your ROI faster than alien blood eats through the bulkheads of the Nostromo.

But, anyway, let’s follow Burley’s example, and pretend John McCants is out of the picture, for now.

Amount of Deposit

As you can plainly see if you look at the Agreement For Sale, the actual deposit was $2,900. Burley is including the first month’s payment with it, effectively making his first “year” include a 13th month. Ironically he can’t even claim that, because his buyers were already in trouble by that time, and paid part of their 13th payment several weeks late. Admittedly, it may seem like quibbling to say the first year cash-on-cash from this deal was “only” 90%, versus 99%, and it might be—if we were talking about someone other than John Burley. Trust me. It’s all downhill from here.

“Contract Profit”

The $16,387—the difference between Burley’s purchase price and his sales price—is made up money. As the term “contract profit” implies, Burley (and McCants) hasn’t actually been paid this money. Instead, what he actually has is a promissory note. If the buyer defaults, any unpaid portion of the balance simply evaporates (and, obviously, so do the profits).

“30 Years”

Burley repeats this one a lot. He loves to give his “students” the impression that, once the buyer signs on the dotted line, no more work will be necessary, other than periodic trips from the mailbox to the bank to deposit the checks. The fact is that most people don’t live in one place longer than a few years—particularly when it’s their first home purchase. Such was the case with this very property. Burley’s buyers, who, as I’ve said, almost lost the house to foreclosure in August of 1999, sold it in October 2005.

Technically, if the house gets sold early, your ROI ends up actually being higher, for reasons I’ll go over in a moment. On the other hand, once the house is sold, you get no more checks. What happens then? Obviously you have to keep finding and buying and remarketing houses. You might be “your own boss” in such a situation, but I’d hardly call it “financial freedom.”

“$324/month for 360 months = $116,740”

Now, there’s no denying that 324 multiplied by 360 is equal to 116,740. However, things get a little more complicated when you start adding words like “dollar” and “month” to the mix.

I find this distortion particularly interesting. It may not constitute incontrovertible proof, but it is certainly very persuasive evidence that one of the following statements is true:

1. John Burley doesn’t understand the time-value of money.
2. John Burley thinks his students don’t understand the time-value of money, and he isn’t interested in teaching it to them.

If #1 is true, then one has to wonder what Burley was learning during the “10 solid years” he “made it [his] mission to locate and study all the information [he] could find on the subject of money.” If, on the other hand, #1 is false and #2 is true then how can Burley claim that he is sincerely interested in “sharing his knowledge” about the “money game”?

Imagine Burley coming to you and offering to give you $324/mo. for 30 years (let’s call it a “promissory note”) if, in exchange, you pay him $116,740 today. Reading his quote above gives me the impression that he would see this as an equitable trade. Hopefully, though, you would recognize it as an appallingly bad deal for you. The question is: How much should you pay someone today in return for 360 monthly payments of $324?

To answer that question you need to know what your other options are (your “opportunity cost”). Where else can you put your money? What if you could choose between Burley’s promissory note and, say, a hypothetical security instrument that pays 6% per year? In that case, you might tell Mr. Burley that you’d be happy to pay him $54,310.68, and not a penny more. Burley, who has just spent $7,549 and taken out a loan for an additional $52,661, politely (and understandably) declines your offer. If Burley seriously wants someone to take his monthly payments, he must continue looking until he finds someone whose next best investment opportunity would pay a maximum of 5.058% interest per year (In actuality it’s worse than that because with Burley’s note there’s a significant risk of default. Note buyers would thus calculate in some discount rate to compensate).

Please note that none of the above illustration is meant to conflate the ROI of the note purchaser with Burley’s cash-on-cash return on his wrap. The ability to use leverage (i.e., OPM) is one of the more attractive aspects of real estate investment. The point I’m making is that Burley is, at best, painting an overly rosy picture (come to think of it, that seems to always be the point I’m making with respect to John Burley!).

Pertinent Costs not included in “Initial Investment”

In keeping with the “overly rosy” theme, Burley fails to include a number of material expenses in his “initial investment” figure. Why doesn’t he mention his staff costs (pro-rated, of course)? Why doesn’t he include his office overhead (again, pro-rated)? Why not the property’s advertising costs? What about its acquisition costs? The house didn’t just fall in Burley’s lap! What about the carrying costs incurred during the 16 days the house sat vacant? Burley includes none of these things in his $7549, yet all of them are real. All of them are significant. This is where I really start to wonder how dumb John Burley thinks his “students” are. Bring any of this stuff up, and you’re bound to hear “Psychobabble! Details don’t matter!” shouted at you, in response.

What about Burley’s time?

Making an accurate estimate of all of the costs I mention above is really an exercise in futility. Your guess is as good as mine. In contrast, determining the lower limit of the value of Burley’s time is a simple matter. We know that if Burley wasn’t being his Level Five Investor self, he’d be in California making upwards of $140,000 per year as a financial planner. We know Burley decided to walk away from this $67.31 per hour, which means he values his time even more than that, but lets stick with $67.31 since we’re sure his time is worth at least that. I think this $67.31/hour is a good proxy for Burley’s expenses, too. After all, you don’t hire staff and occupy an office to make yourself less efficient. All we’re left with, then, is guessing at how much time Burley and his organization spent to make this deal come together.

Was it a week? Then Burley’s ROI on 3320 W San Miguel drops to 66%. Two weeks? Now we’re down to 53%.

You might be looking at those numbers and thinking, “Those are still pretty respectable!” I guess then it’s time to remember that Burley is splitting the profits with an investor. It’s probably also time to remember that Burley’s buyers are necessarily people with bad money-management skills (if they weren’t, they could get a normal home loan like everybody else). Given the tendency of people with poor credit histories to not pay back the money they owe, I would hope that you’d look at the promise of a 26% ROI and see it as a barely acceptable risk premium. Not all properties are bundles of joy, like the San Miguel house. Some, like 2542 W Missouri Avenue, are the demon seed.

Another “Not Special Deal”: 2542 West Missouri Avenue

Purchased in a partnership with his investor Todd Severson on January 13th, 1992, for about $39,000 (based on the loan amount and guessing they put down 10 percent), this house was quickly remarketed to one Gwendolyn R. on the 22nd.

Ms. R’s down payment was almost certainly $1,900, and her monthly payment was $505. If you figure the underlying loan’s interest rate at about 8%, that means that Burley and his partner’s principle and interest payments were around $255/month. Add another $60/month for taxes and insurance, and Burley and his investor were each making roughly $95/month.

Using Burley math, what ROI does that translate to? Initial investment ($4040) divided by deposit plus first year net income ($4300) = 93%.

Everything seemed rosy for over a year and a half. But then, in August of 1993, Gwen missed a payment. In September she missed another one. Then another in October. In a fashion indicative of some measure of uncertainty (read “panic”), and uncharacteristic of his future behavior in this area, Burley sent Gwen two Notices of Forfeiture, the second one a copy of the first, except with additional scribblings to include mention of the missing October payment.

Kicking Gwen out, though, would prove more difficult than just mailing a couple letters. In November she sued Burley and pals, in an attempt to enjoin the forfeiture of her interest in the house. Of course, she was in arrears, and clearly in the wrong (legally, if nothing else), so her suit would only postpone the inevitable. But postponement sounds the death knell for investment returns. In this case it meant zero income from 2542 W Missouri from August 1993 until May 1994, when they were finally free of the lis pendens and found a new buyer. By all indications, this second buyer was trouble-free, living in the house for 5 years, then paying off the loan and, presumably, moving on to a new home.

Now, I ask you, why is it that Burley—a man who is purportedly interested in educating investors—doesn’t include the very educational horror story of 2542 W Missouri as one of the examples in his book? Could it be because Burley isn’t really interested in providing an education?

I leave it for you to decide.

John Burley's Investment Returns

…or: Why Economists Make Poor Entrepreneurs

John Burley declares, at every opportunity, that he routinely gets investment returns of 40%, 50%, or more on his wrapped properties, and “with little risk.” Specifically, he tells his investor partners that he is aiming for (but of course doesn’t guarantee) a minimum first year return on investment for them of 50%—or that’s what he was telling them when he recorded Blue Print for Success back in the mid-90s. I can’t be sure what he is saying now.

However, given that the average return on investment (ROI) in the stock market has historically been around 11%, I don’t believe Burley’s claims are credible—over the longer term, anyway. An explanation of why requires delving into a little economic theory known as the efficient markets hypothesis—or, as Burley might call it, “Psychobabble.”

Of Grocery Store Lines and Freeways

It’s an early Saturday afternoon, and you—and everyone else, it seems—are at the grocery store. When your basket is full and you’re ready to leave, which line should you pick? The fastest, right? Which one is that? As you take the time to figure it out, you notice that other people keep getting into the lines ahead of you, and they all seem to be roughly the same length.

After you finally make it out of the store and you’re driving home on the multi-lane freeway in stop-and-go traffic, you notice the next lane over seems to be moving faster than yours. As soon as you see an opening, you take it. Your victory is short-lived, though. Soon your new lane comes to a stop. You watch in dismay as the car that was behind you in the other lane now zips past you.

Economics 101

The above over-simplified examples serve as intuitive and familiar illustrations of the concept of the “efficiency” of competitive markets (for a more detailed discussion of the above examples, go here to read their source). Stated less colorfully, but in a way that is more relevant to discussing John Burley, the basic idea is this: In a competitive marketplace, where all economic actors have basically the same goals and roughly the same information, excessive profits will be very unlikely.

That’s a bold statement (pun intended), and also rather abstract. Let’s define some of the terms and hopefully make it clearer.

Competitive Marketplace – In this case, I mean Maricopa County’s residential property market, and specifically the market for home buyers who have a poor credit history. Is this market competitive? I can’t speak for what it was like in the early 1990s, but a quick search through the real estate classifieds at http://www.azcentral.com/, using keywords such as “low down,” “ez qual,” “no bank qual,” “bad cred,” etc., ought to at least give you pause. If he ever was, Burley is clearly no longer the only game in town.

Economic Actors – By this I mean all the buyers and sellers of single-family homes in Maricopa County—and mostly I mean the Investors.

Same Goals – Investors are interested in getting the highest ROI. Sellers are interested in getting the highest price for their property. Buyers are interested in buying the nicest house that they can afford.

Same Information – All the economic actors know (or should have at least a basic understanding of) what home prices, rents, interest rates, etc., are doing. None of the economic actors can see the future. None has secret knowledge that is unavailable to the rest—at least not on a consistent basis.

Excessive Profits – I am not using the word “excessive” in a normative sense, here. In a free market, high profits serve an extremely useful social function: They are a signal or a guide to entrepreneurs about where there exists unmet consumer demand. Profits attract investment dollars to where they are needed most, as defined by the consuming public. In a very real sense, consumers vote for the best entrepreneurs with the dollars they spend. So here I am defining the word “excessive” as simply “higher than around 11%,” since that has been the long-term historical average ROI of the stock market.

The Hypothesis Expanded

So, now we’re in a better position to explore why it is that John Burley is almost certainly, um, let’s say, “stretching the truth” when he claims he regularly gets 50%, or higher, ROI with his wraps.

Burley would like to buy an investment property for as cheaply as he can get it. Unfortunately for him, the state isn't going to give him a monopoly on the Phoenix housing market, so he can't just name his price and expect all sellers to just roll over and take it. He is competing with all other homebuyers in the market. That includes other investors, out for a bargain purchase, and “retail” homebuyers, who aren’t necessarily looking for a bargain so much as looking for a home that they will enjoy living in. Thus, the retail purchaser will usually be in a position to outbid the investors for a given home, assuming 1) that the home doesn’t have some hidden serious defect, or 2) the investor(s) didn’t find out about the property before the retail buyer even had a chance to bid.

Unless Burley can come up with some ingenious ways around the above problems—ways that he can keep secret from all the other buyers, so that they can’t also use them—he is going to have to deal with buying homes usually at a higher price than he would want, and expend time and money searching for longer than he would want, both of which negatively affect his ROI. On Blue Print for Success, his only advice is to “make lots of lowball offers” until you get lucky and some dumb/desperate seller accepts. Is this a “costless” strategy, do you think?

Once Burley finally gets lucky and buys an investment property he’s up against a different set of problems. He’d like to sell his place for as much as possible, but he can’t ask too much, because then his house will sit vacant as buyers go elsewhere. Other investors are as motivated as he is to attract the finite set of homebuyers, and this process of attraction costs money—either in terms of advertising costs, repair, maintenance, or upgrade costs, or an attractive purchase price or terms—all of which, again, negatively affects Burley’s ROI.

As the number of investors rises in a given market, the competition for the same resources (meaning properties and buyers) increases. John Burley, just like the rest of the investors, then faces a choice: lower your expected ROI, to compete, or suffer losses from properties sitting unsold. Over time, this forces the average ROI of all investors down to a level where they are basically doing something a little better than 11%. Those investors who don’t meet that ROI either go broke or decide (wisely) that their money would serve them better if, instead of using it to wrap houses, they put it in, e.g., an index mutual fund.

Now, admittedly, this analysis is still a bit simplistic, but the burden of proof is on John Burley to show that he really is getting consistently “excessive” returns (and then to show how he’s doing it, since he claims to be providing “the highest quality real estate investment, wealth-building, and debt-free lifestyle information”). Of course the irony is that as soon as he’s revealed it, nothing precludes his competition from adopting his techniques and putting them to use against him. That might go a long way toward explaining why he’s so fond of yelling “Psychobabble!” when people ask him “How?”

As you probably know, I’ve been looking at Burley's public record. I hope, therefore, that I’ll be able, in an upcoming post, to take a close look at one or two of Burley’s investment properties and get at least some rough approximation of their actual ROIs. Stay tuned.