I wanted to use this space to tie-up a few odds and ends. I promise* the ideas here (although wide-ranging) will be valuable and I’m very hopeful that they will improve your ability to get more value in life - when you shop, invest, and sell goods. In the last section, I share a new visual to show underlying performance factors of my value fund.
Lessons of residual value & deprecation trends
First, I want to discuss residuals and residual value.
The Oxford Dictionary defines a residual as “remaining after the greater part or quantity has gone,” and;
Investopedia defines residual value as “the estimated value of a fixed asset at the end of its useful life.”
The term “residual” is a niche term not commonly used, please don’t get hung up on it (depreciation is likely a more commonly used term to describe a similar concept). The point I want to make is that how you think about the value of an asset at the end of its usefulness can totally change the cost and value. It can make expensive assets more affordable than cheap assets. If you have heard of residual values before, the term was likely used in relation to cars or trucks. I’ll start with a simple example in that space before I move to other asset categories. I believe Chevrolet Trucks advertised that they had the highest residual value heavily in the nineties. Yet today, it appears that the truck that holds its value the best over time is the Toyota Tacoma. Regardless, I’m guessing you have seen a graph similar to the ones below as you researched the pros and cons of buying a new or used car.
The actual numbers here aren’t super important, the trend is… I’ll walk through a really simple example using the graph above to illustrate a point. If you need a car for a year, how old of a car should you buy? Obviously, this depends on a number of complex factors, but if it’s just a decision based on the value lost - the car loses $1,607 of value from year 4 to year 5 ($10,719 - $9,112) vs. $6,250 from year 0 to year 1 ($25,000 - $18,750). As I mentioned, this concept seems fairly elementary (and well understood), I think the real power comes from applying it to areas where people forget about the residual value. Many people have made businesses to fill this void, why do you think people are offering to haul away your used appliances for free? They are gambling that the appliance you have decided has a residual value of zero (to you) has a residual value of greater than zero to someone else. Think about the deprecation curves above, as well, different products and different brands depreciate at different rates (think about a Toyota Tacoma vs. a Kia, Patagonia vs. Old Navy, or Nike vs. Unbranded Shoes). It is really valuable in life (and in investing) to understand how you can play the depreciation curve to your benefit (adjust the slope or understand how time influences the residual value). Time plays an important role here. The decision making process will be entirely different if you plan to use (or invest in) an asset for two years vs. ten years. Regardless, I hope you find the following examples thought-provoking:
You need a winter coat. You might buy a $500 coat. You might buy a $100 coat… have you considered buying a $500 coat that is 12 months old for $200, wearing it for two years and reselling it for $160? The third option isn’t for everyone (it likely isn’t for most people) but does provide the lowest cost per day to use the coat. You also get to use the much more expensive coat (which we assume is warmer, more comfortable, etc.). The third option seems like a huge benefit to me, because you are using your understanding of residual values and the depreciation curve to get the most premium product at the most affordable price.
***I understand I’m making some assumptions here… maybe you could sell the $100 coat for $60 two years later (I doubt it). Maybe you could get a friend to give you a coat for free. Maybe you wear the $100 coat for 30 years - that’s sweet. Maybe you don’t have $200 to spend on a coat. My point is to think about when option 3 might be ideal for you, so don’t get too hung up on the details.***
You need a car. You might buy a new car. You might buy a used car. What if you bought a used car that is scarce… like a late 60’s Mustang or an early 2000’s EuroVan. That choice might turn the depreciation curve into an appreciation curve. This is another example of approaching this challenge differently to get more value from the situation. The investing possibilities are numerous, anytime you acquire an asset you might be able to use the expected residual value to change the question in your favor.
You are buying a stock. You might buy the stock of a brand you like without understanding the financials (but please don’t). You might buy on a tip from a friend (but please don’t). What if buy because the stock was selling for $9 per share but it had $7 per share worth of assets (from cash to real estate to inventory, etc.). Maybe that turns the potential investment into something with very limited downside risk and huge upside potential.
You are buying exercise equipment or music equipment. You might buy new equipment… but you should probably buy used equipment. Exercise equipment and musical instruments are items that are frequently purchased new and lightly used. They are both great examples of items where the depreciation curve is (often) very steep in the first few months of use. I think you might be surprised by the number of bands that play with used equipment (random fact: the Beastie Boys bought the majority of their equipment for the Check Your Head tour from a small, weekly newspaper in L.A. called The Recycler).
A quick disclaimer: this isn’t easy. You have to know and understand the asset well, if you don’t (and in some cases, even if you do) you can lose money be misestimating the residual value. I hope you found this to be a worthy thought experiment though. I think residual value (depreciation curves) help explain a significant amount of day-to-day economics, like why renters that drive new, expensive cars are renters and not yet homeowners… so much of the monthly income is being eaten about the depreciation curve. I’ll close a graph of Jordan shoe prices over time to (hopefully demonstrate) how this concept can be used almost anywhere.
Resell trends of Jordans
Residual value is applicable everywhere
Understanding components of performance
In my experience, understanding the key drivers of the performance of a mutual fund or ETF can be very difficult. If you hold an S&P 500 ETF that is weighted by market capitalization (this is typical) you are holding ownership rights to approximately 500 different companies, but you only see one performance figure for your fund. About 22% of the assets are concentrated in the ten largest companies (AAPL, MSFT, etc.). This makes it hard to determine the impact of any specific stock on your total return. There are some good tools out there to dig into this, which I plan to write about in future newsletters… For now, I want to share a visual I’ve created to help tell the story. Below is a breakdown of the performance of my value fund. The light lines show the individual performance of each stock held in the fund and the dark line shows the combined performance of the fund. Several factors make this visual possible (and hopefully valuable) - the fund is small (<10 holdings) and the holdings are equally weighted (a market-cap-weighted fund would tilt the overall results towards the performance of the largest companies). Let me know what you think of the graphic below because I hope to expand on this analysis in the future.
*good luck with this promise… I should say “I hope”