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Ideas Farm: For flip's sake!

Some markets are not really markets. Watch out!
November 11, 2021
  • Can big data figure out the residential property market?
  • Not yet.
  • Is it a real market anyway?
  • And what about micro caps?
  • Plus loads of new idea generating data.

When I was buying my first flat in the mid-noughties, my dad, a residential-property surveyor and veteran of the early-1990’s housing-market meltdown, had a piece of sage advice that has stuck with me: “The house market is not really a market”. 

This is something that US-property listing site Zillow has recently learned, and taught its shareholders the hard way.

For those unfamiliar with the story, Zillow decided to extend its online property-listing business into property flipping. With a few clicks of a mouse, house sellers in hot parts of the US market could offload their property to Zillow. Using all kinds of technological wizardry, Zillow would then aim to speedily sell the units on for a profit. And with 9.6bn site visits last year, the company certainly had enough data to crunch for the property-flipping algorithm that sat behind this venture.

The trouble is, no matter the amount of data crunching, the company has not been able to accurately assess and predict property prices. It’s been an expensive and humbling big-data foray. Zillow expects a $500m-or-so write-down as it winds up the ill-fated flipping venture on top of losses already booked. The US market has not even had to falter much to force this capitulation. 

Residential property is at the extreme example of a 'market' that does not fit with our textbook ideals of what a market should be. Each home traded has its own unique characteristics that need to be considered separately to what seems readily observable from data. 

What’s more, transactions are often highly emotional. Legalities are complex. Transaction periods are long. But perhaps most strikingly of all, in property markets, liquidity vanishes without warning. When a market is most needed by sellers, it is often simply not there.

There are lessons for stock market investors in Zillow’s recent travails, aside from the need to be skeptical about companies that commit large amounts of capital to projects that radically depart from their core businesses. The stock market's lessons are especially pertinent to investors in smaller companies, and particularly those who dare to venture far down the market cap spectrum; companies worth tens rather than hundreds of millions. These parts of the stock market are often best understood as 'not really a market'.

One of the attractions of investing in smaller companies is that private investors can genuinely hope to build an information advantage. That’s to say, an advantage based on superior fundamental analysis. With larger companies, the tireless research of professionals tends to eliminate this type of edge. But professional interest in small companies is low as it is often impossible to deal in meaningful sizes – but what is meaningless for a fund is often still very meaningful for an individual. 

But while the absence of professional investors creates opportunity, it comes with serious drawbacks, too.

The research hours and money professionals put in create better pricing and more ordered trading. Sentiment can run rife when professionals withdraw. Herding can become endemic. For those that lack a deep understanding of what they are doing, this can be hugely dangerous. The temptation is always to jump on hot stories late in the day, only to find there is no liquidity when sentiment turns. For the inexperienced, investment decisions become things based on 'belief' rather than the cool-headed assessments of probabilities. 

Enough 'belief' can sustain a share price for a long time. But, ultimately, when reality creates cracks in a story, a lack of liquidity means the downside is perilous. Holders are left in a situation as bleak as that of highly-mortgaged home-sellers during the 1990’s recession. There are no buyers.

The best way to protect oneself is a familiar one: thorough research and a strong investment process.