You have probably heard financial advice in the form of phrases such as;
- “invest in companies with strong fundamentals”
- “Companies with growing cashflows outperform over time”
These phrases and other similar utterances have become ubiquitous in the financial world. They seem conservative and wise, so financial professionals know they will not get in trouble for doling out such advice.
Digging deeper, these phrases are nothing more than platitudes that reveal a particular style bias. Companies with strong fundamentals and growing cashflows feel better to invest in and most prefer to invest in this sort of vehicle, but are these really better investments?
The core flaw with these pieces of advice is that it assumes that when a company does well the stock will go up, but they ignore a crucial piece of information; the price. Anyone with a basic understanding of finance can identify companies that are likely to do well, but doing well does not necessitate generation of total return for the investor. If a company does well, but was expected to do extremely well, total returns may actually be negative.
The key question we should be asking is not which companies will do well, but rather which companies will do well relative to expectations that are implied by the market price.
To address this question, we can begin by defining expectations as the market implied outcome. When the market trades a given stock at a given multiple of earnings, it is implying a certain growth trajectory. It is the delta between the implied growth trajectory and the actual realized growth trajectory that determines whether a stock does well. If the actual growth trajectory fails to meet the market implied growth trajectory, the stock should go down.
This sort of scenario can be illustrated as follows.
The stock at present day (time 0) is trading at a very high multiple which is the market implying or expecting a rapid growth rate. Through discounted cashflow or other similar analysis, price to earnings multiples translate into a particular growth expectation shown above as the red circle at time 0.
That is the amount of growth the stock needs to achieve in order to justify the current price at which the stock is trading. If in the future (time 1) it turns out that the stock’s growth is weaker than what the market was implying, shown as the red bubble on the right, the stock should drop in price.
The magnitude of price drop should be proportional to the vertical deviation between the market price implied growth and the realized growth as seen below.
Market implied outcome
In looking at where a stock is presently priced it is useful to be able to infer what the market is expecting to happen. The implied outcome of a given multiple depends on a few factors.
- Prevailing risk-free rate
- Risk premium of that particular stock or industry
- Cyclical state
Presently the so called risk free rate which is often measured by the 10-year Treasury yield is quite low. This means multiples are higher by default. Many years ago, when risk free rates were higher, a PE multiple of 20X implied a market expected outcome of rapid growth. Today, given where Treasury yields are, a 20X multiple only implies market expectations of slow to medium growth.
Risk premium also plays a role. For industries or particular companies that the market views as safer, the required rate of return is lower. Thus, a 25X PE multiple implies more growth for a risky stock than it does for a relatively safe stock. In other words, the market does not require as much growth to justify the high multiple in the safer stock.
Earnings multiples should naturally fluctuate based on where a company is in its cycle. When it is near a trough, multiples should be higher and when it is near a cyclical peak, multiples should be lower. Essentially, the correct multiple to look at is the price relative to cyclically normalized earnings.
With all of this in mind, one can get a decent picture of what the market requires of a stock given where it is trading. Let us put this into practice with REITs.
We can begin by establishing a baseline. The median REIT trades at a P/FFO of 16.2X and the median consensus growth rate from 2019 to 2020 is about 5%. We can plug this into a simplistic DCF style model using some basic assumptions.
We are assuming the abnormal growth rate of 5% lasts for 5 years after which point it returns to a 2% growth rate in perpetuity (roughly inflation). For ease of math, let us use a $10 stock price. A $10 stock trading at a 16.2X multiple generates $0.62 of annual FFO and we can use this figure as our year 1 FFO.
The FFO for each year including the continuing value year can then be discounted back to present value. We let the discount rate be the plug figure and a present value of $10 (which equates market price) returns a discount rate of 8.72%.
In other words, the market is demanding an 8.72% expected return for a REIT of average risk. This happens to be reasonably close to the long run historical annualized return of REITs so it seems to be in the right ballpark. Now that we have a rough idea of the expected return of the average REIT, we can use this number to form the market implied outcome of individual REITs. Specifically, we can get a sense for how fast a REIT of a given FFO multiple must grow to meet the expectations implied in its market price. The results are summarized in the table below.
Source: author generated in Excel
A REIT trading at a multiple of 5X that loses 28% of its FFO annually for the next 5 years should return about 8.72% annually.
A REIT trading at a multiple of 35X that grows its FFO by 30% a year for 5 years should return about 8.72% annually.
The platitude style advice we discussed at the start of this article really misses the mark when it comes to very cheap and very expensive REITs. I think most people would agree that a company that is positioned to grow its earnings by 10% a year for the next 5 years is in a fundamentally strong position. So if one is following the advice of “buy fundamentally strong REITs”, this would look like a clear buy.
However, if this stock is trading at a 25X multiple, a 10% growth rate will result in it severely underperforming. The company needed to grow 19% annually just to meet the expectations implied by the market price. Conversely, a company with a flat growth outlook that is trading at 10X is a great buy as the market is implying annual declines to FFO of 9%. Despite the superior return potential, this stock would be overlooked by someone following the platitude style advice.
With that in mind, let us get to some real examples
Public Storage (PSA) is trading at 21.2X 2020 estimated FFO, so to generate a market equaling return it would have to grow FFO/share at about 13% annually. The market price implies a growth rate that is vastly out of touch with reality.
In PSA’s most recent report it became clear that operations are becoming troubled.
- Q3 same-store net operating income fell 0.9% Y/Y.
- Q3 same-store gross margin of 72.0% slips from 73.5% a year earlier.
Due to external growth, PSA was able to squeak by with positive FFO/share growth of about 3%. This growth is nowhere close to enough to justify its lofty multiple
Extra Space Storage (EXR) has over the past decade been the best operator in the self-storage sector and even they are having issues. In their 4th quarter report, EXR guided for 2020 same store NOI growth in a range of negative 0.5% to 1.0%. It is related to significant oversupply and now product keeps being developed. We see self storage as a flat to negative growth sector yet multiples remain inflated. Public Storage, in my opinion, is the best short selling opportunity in the group as it has older properties and is far behind its peers in digital advertising.
Another overpriced area is industrial REITs which have a median multiple of 25X.
Some of the industrial REITs actually have managed to produce the 19% annual growth rate that is implied by the market pricing the sector at a 25X multiple. However, I have serious doubts about the duration of this growth.
I get that there are secular tailwinds in the form of e-commerce driving demand for logistics space, but this tailwind is being fully countered by supply growth. 2020 is projected to be the first year of this cycle with negative net absorption. Demand remains strong, but supply growth is so massive that new square footage is actually outpacing incremental demand.
Further, industrial REITs are a highly cyclical sector and analysts will differ on whether we are in the 6th inning or the 8th, but it is clear that we are late cycle. As a cyclical sector nears its peak, it should trade at a discounted multiple, not a premium. During the financial crisis, industrials were among the hardest hit REIT sectors, and while I am not anticipating anything anywhere near that bad on the horizon, the sector still looks overpriced for even a run-of-the-mill recession any time in the next 10 years.
That said, I want to be careful not to paint the sector with a broad brush as there is a good deal of pricing variance within the sector. STAG Industrial (STAG) Plymouth (PLYM and perhaps Monmouth (MNR) are trading at a reasonable valuation while Terreno (TRNO) and Rexford (REXR) are at copious multiples.
Terreno’s 40X multiple means that in order for TRNO to outperform the market it will have to grow at a pace of greater than 35% annually for the next 5 years. That strikes me as bordering on impossible. Considering the sell side consensus estimate is only calling for 10% growth in the next couple years, someone is very wrong.
Source: SNL Financial
Given the supply issues facing the sector, I’m betting the analysts are closer to right and that the market price has gotten out over its skis.
Iron Mountain (IRM) is trading at 10.5X forward AFFO; a price which implies roughly negative 8% growth annually for the next 5 years.
This is way out of line with both IRM’s long track record of growth and their forward guidance. In the 4Q19 earnings report, IRM issued guidance of 9-12% AFFO growth in 2020.
Significant box volume growth in the international division along with a sizable lease-up pipeline for their data centers suggest this level of growth is possible. The market is skeptical, but even if IRM misses guidance and only grows 5% it is a steal at current market pricing.
Perhaps I talk about malls far too often, but I think it is absolutely crucial to think about malls in the lens of market implied outcome. Put simply, being bullish on mall REITs does not require one to believe they will be extremely successful. Stabilization is enough for the entire mall REIT sector to massively outperform the market.
While the market is somewhat guilty of following the “buy companies with strong fundamentals” when it comes to overpriced companies, it is far more guilty of translating that advice into “sell companies with weak fundamentals” I believe market participants are selling malls because they believe FFO will continue to decline and they are not following through with the math of what that decline means for intrinsic value. Perhaps the numbers will make my point clearer.
The average mall REIT is trading at a P/FFO of about 5X. This implies negative growth of 28% annually over the next 5 years. 2018 and 2019 were dark years for mall REITs, but none of them declined anywhere close to this pace. Even CBL Properties (CBL), which is arguably in the weakest position, lost FFO at a much slower pace.
Source: SNL Financial
Analysts are projecting slight declines in 2020 for CBL and slight gains for the higher quality mall REITs (Pennsylvania REIT (PEI), Macerich (MAC) and Simon Properties (SPG)). Washington Prime (WPG) is also anticipated to grow FFO/share by a penny. 2021 is expected to be a slightly stronger year than 2020. Redevelopments will largely be complete and the new tenants will be in and cashflows for the REITs.
The gap between what is implied by market prices and what is being forecast by analysts and management teams is truly staggering. Let us look at WPG to illustrate this gap.
Management at WPG and the sell side analysts are calling for basically a flat trajectory. If we plug this flat trajectory into the DCF, it returns a present value of $15.09 or a bit more than 5X current price.
It would be entirely fair to put a higher discount rate on a risky stock like WPG, but the difference between analyst consensus and what is implied by the market is staggering.
If the analysts are even close to correct (which my research suggests they are), the mall REITs are well positioned to outperform.
Wrapping it up
DCF’s and other similar models are quite sensitive to the input assumptions. I like to gut check them against other forms of fundamental valuation to ensure they are in the right order of magnitude. The models presented in this article are far too simplistic for actually valuing a stock. Instead, they are for illustrating the concept of what is implied by a market price.
We all know that 30X is a high multiple, but I think it is important to have a rough mathematical understanding of what a 30X multiple requires in terms of future growth rates. Many of the 30X multiple REITs are not growing anywhere close to fast enough to justify the lofty valuation. Be careful when wading into luxuriously priced REITs.
Disclosure: 2nd Market Capital and its affiliated accounts are long IRM, STAG, SPG, CBL-E, CBL-D, MAC, PEI and WPG. I am personally long IRM, STAG, SPG, CBL, CBL-E, MAC, PEI and WPG.
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Disclosure: I am/we are long SPG, WPG, CBL, CBL.PE, PEI, STAG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am personally short PSA
Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.