Why Opportunistic Investors Loathe A Calm And Happy Market

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 |  Includes: AHT, IRC, LSE
by: Dane Bowler

December has brought with it the rare phenomena of a marketplace that seems rational and properly values issues. This article will explore specifically why such a market makes opportunistic investing difficult, and what investors can do to maintain superior returns.

Over the past few months, opportunistic investors have enjoyed a marketplace full of panic, greed and generally erratic behavior. This wonderful period seems to have come to a close, leaving us with more difficult choices in terms of where to allocate investment. We will begin with the 6-month graph of the MSCI REIT index as it is illustrative of two points essential to this theme:

(click to enlarge)Click to enlarge

  1. There has been considerable short-term volatility
  2. The market has not moved much over the entire 6-month period, up only 4.4%

In the emotionally driven volatility, pricing got out of sorts creating great opportunity. Specifically, certain strong companies were trading at irrationally low multiples. As examples we can look at CapLease (NYSE:LSE) Ashford Hospitality Trust (NYSE:AHT) and Inland Real Estate (NYSE:IRC).

CapLease: This strong and stable earner experienced a massive drop resultant from an equity offering. It briefly traded at absurdly low multiples for a triple-net REIT.

Ashford: Despite continual stellar performance AHT traded at an earnings multiple as low as 4.

Inland: Continuously improving earnings were not met with equivalent gains in market price so its multiple trended lower and lower. This process climaxed with a major shareholder selling high volumes into a void that dropped its price almost 25% in a matter of hours.

These opportunities came to fruition and now trade at multiples closer to the normalized values, and similar movement happened to value stocks in general. As previously mentioned, the overall REIT market did not move much, instead reallocating; fully valued stocks holding or going down slightly and value stocks coming up materially. This creates an overall tightening of multiples and a marketplace that is closer to right. In other words, the market has balanced itself such that there are no glaring opportunities. The remaining issues trading at low valuation are there for a reason (nearly bankrupt or continuously troubled) and those trading at a premium are justified by exceptional performance. As evidence to this point, we can look at the June 2012 and December 2012 multiple spreads between the lowest valuation and the mean in each sector of REITs. Those of you who find the extensive data that led to my conclusion tedious may skip to the last box in which the sector data is aggregated, but I have included all of the data for verification.

Multifamily/Residential

Sector's lowest multiple

Sector's average multiple

Deviation between lowest and mean

June 1st 2012

12.2

17.3

5.1

December 1st 2012

12.1

16.3

4.2

Change over period

-0.1

-1.0

-0.9

Click to enlarge

Retail

Sector's lowest multiple

Sector's average multiple

Deviation between lowest and mean

June 1st 2012

6.6

14.3

7.7

December 1st 2012

9.1

16.0

6.9

Change over period

+2.5

+1.7

-0.8

Click to enlarge

Industrial

Sector's lowest multiple

Sector's average multiple

Deviation between lowest and mean

June 1st 2012

11.8

13.7

1.9

December 1st 2012

13.6

16.6

3.0

Change over period

+1.8

+3.0

+1.1

Click to enlarge

Office*

Sector's lowest multiple

Sector's average multiple

Deviation between lowest and mean

June 1st 2012

8.3

11.9

3.6

December 1st 2012

8.9

12.2

3.3

Change over period

+0.6

+0.3

-0.3

Click to enlarge

Healthcare

Sector's lowest multiple

Sector's average multiple

Deviation between lowest and mean

June 1st 2012

9.3

14.2

4.9

December 1st 2012

11.0

16.4

5.4

Change over period

+1.7

+2.2

+0.5

Click to enlarge

Self Storage

Sector's lowest multiple

Sector's average multiple

Deviation between lowest and mean

June 1st 2012

15.5

17.3

1.8

December 1st 2012

19.2

20.9

1.7

Change over period

+3.7

+3.6

-0.1

Click to enlarge

Hotel

Sector's lowest multiple

Sector's average multiple

Deviation between lowest and mean

June 1st 2012

4.3

11.0

6.7

December 1st 2012

6.6

12.4

5.8

Change over period

+2.3

+1.4

-0.9

Click to enlarge

Diversified

Sector's lowest multiple

Sector's average multiple

Deviation between lowest and mean

June 1st 2012

6.2

14.2

8.0

December 1st 2012

7.6

14.7

7.1

Change over period

+1.4

+0.5

-0.9

Click to enlarge

Aggregate Equity REITs

Average lowest multiple**

Average multiple ***

Deviation between lowest and mean

June 1st 2012

9.275

14.2

4.925

December 1st 2012

11.0125

15.2

4.1875

Change over period

+1.7375

+1.0

-0.7375

Click to enlarge

*MPG office trust and Commonwealth were excluded from consideration in the office sector as unique situations make their multiples not reflective of valuation.

**Avg. lowest multiple calculated as the average of the 8 data points from each sector above.

***Average multiple change from published averages of 14.2 in June and 15.2 in December.

When stated in this form, the change may not seem like much, but that translates to the cheapest stocks of each sector having come up 18.7% on average in just 6 months. That is a whole lot of opportunity that no longer exists in this nearly normalized market.

In a perfectly normalized market, all issues would be priced such that investment generates the same risk-adjusted returns regardless of what you choose. Obviously, the market is not there yet, but it is closer than it has been in a long time. How then, can savvy investors get above-market returns in this environment? Big opportunistic plays are harder or impossible to find, so instead we can rely on a variety of slight advantages.

  • Intra-company arbitrage: occasionally identical or nearly identical issues from the same company can come out of parity by a few percentage points and investors can capitalize on the return trip. This most commonly occurs with preferreds trading at different active yields, but swapping between preferred and common in a well-timed fashion can have similar results.
  • Continue to invest in undervalued stocks as there is still some room, while diminished, for improved trading multiples.
  • The same risk adjusted returns means stocks that are riskier should on average return more to investors to equalize the risk. One can get ahead using this by investing in a way that reduces risk while maintaining returns. Covering with puts or options does NOT count since doing so will reduce average returns in favor of consistency. Instead, there are various free hedging tactics such as shorting an overvalued stock of the same risk profile as the one you are long. I cannot include an exhaustive list here, as each investor has his or her own clever ways of doing this.
  • Most importantly, keep up to date on a wide range of stocks so as to be ready to capitalize on any opportunity no matter how fleeting it may be.

Fortunately for opportunistic investors, this period of calm normalcy seems unlikely to last long. Regardless of how the fiscal cliff is solved (or unsolved) it is sure to instill emotion into the investing community that will undoubtedly create those sizable opportunities that we yearn for.

Disclosure: I am long LSE, IRC. 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.