“You better cut the pizza in four pieces because I’m not hungry enough to eat six.” —Yogi Berra

While the election dominated the national news, market watchers were also focused on a change to the way that the S&P 500 is constructed. Since 1999, the S&P 500 has been governed by the Global Industry Classification Standard (GICS), a system that essentially slices and dices the market into its component sectors and industries. This past September, GICS was changed for the first time since its creation to elevate “Real Estate” from its status as an Industry Group under the “Financials” heading to a starring role as its own Sector.

Common sense dictates that changing how an investment is “classified” should not change the value of the investment, just as cutting a pizza in four pieces rather than six doesn’t change how much pizza there is. However, as I am fond of saying, common sense is uncommon on Wall Street, and according to an article on REIT.com, the change in GICS is expected to result in “$30 billion to $100 billion in new capital coming into [real estate stocks], as equity funds that have been significantly underweight in real estate look to achieve a market-neutral position.”

That billions of dollars are expected to flow into REITs simply because of how they are “classified” is an excellent illustration of why so few investors are able to outperform the market over time. It should be obvious that the ultimate value of the real estate in question will be a function of the value of the cash flows that the properties can generate over their lifetimes, but billions of dollars are expected to ignore the cash flows, and jump into real estate stocks based on classification alone.

These are the people that I want to compete against in the investing world. They are so afraid of under-performing the market in the short term due to under-owning real estate versus the index that they are willing to completely abandon the most basic principles of valuation. Contrast this approach with our own style of ignoring the indexes while patiently digging through the hidden corners of the markets looking for true anomalies, and you will understand why I am confident in the future of our partnership.

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The above post has been excerpted from a recent letter of Laughing Water Capital.

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