I find it amazing that some of the wealthiest investors around - the hedge funds - claim to have a vast knowledge and understanding as to the nature of their complex strategies, yet the funds' overall performance often turns into Fool's Gold.
We all know that hedge funds by nature are opportunistic as they are designed to pool people's money to invest in a diverse range of assets. Because hedge funds are lightly regulated (and are not sold to retail investors) they typically buy riskier positions and they often employ the use of short selling and leverage.
Although it is difficult to evaluate hedge fund performance compared with other investments (because the risk/return characteristics are unique), I still remain baffled as to why so many hedge fund managers cross into my sweet spot - REITs - trying to short a particular stock that is anything but distressed or even showing signs of weakness.
I can see the reason why the $12 billion hedge fund Pershing Square took advantage of the falling value in General Growth Properties (NYSE:GGP) back in 2009. That was a wise bet for William Ackman (who runs Pershing Square and Forbes values Ackman's net worth at $1.2 billion) who has a history of investing in distressed real estate. But history has also shown that there is little opportunity for the short sellers who pursue high-quality REIT stocks.
For example, in 2009, Ackman waged a battle against Realty Income (NYSE:O) on the thesis that the "monthly dividend company" had poor credit quality. Ackman argued that Realty Income was suffering from mispriced risk since the REIT was paying a dividend of around 7.5% while the private market cap rate values were closer to 10.5% - a 40% premium. Ackman was suggesting that Realty Income's fundamentals could not support the dividend and that a cut was imminent. Boy was he wrong!
Hedge Funds and REITs Don't Mix
Last week I was a guest on Fox Business and during that segment there was a brief discussion comparing hedge fund returns with REIT returns. As Adam Shapiro, with Fox Business, mentioned in that interview,
Billionaires are supposed to know better.
Shapiro went on to "call out" Greenlight Capital (+ 5.7%), Paulson & Co. (up 3.4%), and Pershing Square (+4.6%) as a trio of hedge funds with poor operating results. As Shapiro observed, hedge funds have been on an under-performance run, not hardly what you would expect in a bull market today.
Similarly, in a standing room only conference last week, hedge fund billionaire John Paulson argued that investors should stick with managers for the "long term" and he reminded the audience that he had made billions in the past.
Who cares? I want to invest in the here and the now. Not just a billionaire's track record or his lucky bets. I'm looking for steady and reliable performance in which I can sleep well at night. Not home runs but simply singles would be fine. I guess Mr. Paulson is happy with striking out in anticipation of the home runs he may or may not hit. I thought his comment last week was fittingly amusing:
Don't focus on weekly or monthly returns.
Are you kidding? Should investors just try sleeping well at night knowing that they can rely on Paulson's record subprime trade which netted the billionaire fund manager $4 billion in 2007? Or maybe you can crawl under the pillow at night knowing that the billionaire made $5 billion on a timely gold trade in 2010? Is that how hedge funds operate? Just keeping swinging the bat and maybe after several strike outs a ball finally clears the fence.
Not me. I can't drive for show but I know how to putt for dough. That's also the case for dividend investors. So why then is Jonathon Jacobson of Highfields Capital Management LP shorting Digital Realty Trust (NYSE:DLR)?
Digital Realty: The Cloud Ain't Going Nowhere But Up!
A few months ago (February 11th) I wrote an article on Digital Realty. In that article I wrote:
I recommend Digital Realty shares at the current price of $65.40. Digital is indeed the "big dog" of the Data Center space. In addition, Digital has a proven track record for paying and maintaining dividends, and with considerable demand for high-quality data storage, the big dog has plenty of room to run. Digital Realty barks louder than the smaller peers as the San Francisco-based REIT has a beastly dividend yield of 4.46%. But get ready; Digital Realty should be a valuable REIT companion in 2013 as I expect continued dividend increases as well as strong appreciation.
Did Highfields Capital bother to read my article (Just kidding)? But even if the founder and CEO, Jonathon Jacobson, did read my article he would have at least understood that Digital Realty has a tremendous competitive advantage. Heck, we all know that competition is increasing in the data storage sector but as I wrote in my previous article:
Digital Realty has clearly become the "big dog" in the digitalized Data Storage sector and the company's "core of competence" has also been its primary value proposition. With a strategically-aimed objective of data storage expertise, Digital Realty has become a massive "railroad of this generation providing the infrastructure to support the global economy.
Highfields Capital (with assets of around $11 billion) maintains that Digital Realty is an expensive REIT and the shares should be trading for around $20.00 per share. Jonathon Jacobson of Highfields stated (at the 18th Ira Sohn Investment Conference last week) that:
Pricing is going lower, competition is increasing, and the company is tapping into capital markets as aggressively as they can.
Do you want to pay three times book value for this?
That sounds like a hedge fund manager comment. It's ludicrous that Highfields would be shorting a blue chip REIT like Digital Realty and then saying that the shares are expensive based on "book value." Why?
In REIT-dom book value (and related price-to-book ratios) are often dubious in regard to general equity analysis and they are virtually useless for REITs. A more common metric is Net Asset Value (or NAV) since this valuation is a much better estimate of market value. Furthermore, an intelligent investor would also consider the most common way of calculating a REIT stock: P/FFO (or Price to Funds from Operations).
It's common for most REIT analysts to evaluate REIT earnings with FFO and Adjusted Funds From Operations (or AFFO) rather than Generally Accepted Accounting Principles (or GAAP), since that requires using depreciation which is not always in line with reality. It's logical to use ratios that REIT investors utilize and the P/FFO and P/AFFO ratios are a sound way to compare REITs.
Digital Realty has a market capitalization of $8.41 billion and shares closed on Friday (May 10th) at $65.51. With a total capitalization of around $13.8 billion, Digital has one of the lowest P/FFO multiples. I find that is especially attractive, especially since I consider Digital a player with blue chip REIT credentials (see my article here on Blue Chip REITs).
It's almost like Highfields thinks that Digital Realty is a dot.com company, not a data sector REIT. Why else would investors, led by Highfields, short around 18 million shares of Digital Realty, or 14% outstanding. Here is a snapshot of DLR's trading volume last week: (click to enlarge)
Highfields claims that Digital's fundamentals are deteriorating and the dominating data sector REIT is a commodity business with no barriers-to-entry. Simply said, Highfields is shorting Digital because they think they know something others don't know. They are plain and simple: speculators, obsessed with dangerously manipulating prices and driving down prices for their own personal gain. Remember, that is the motive of a short sell investor and the sad truth is that investors should not condemn Highfields but instead remain aware and act with cautious skepticism in any interactions. But now, I will set the record straight…
The Intelligent REIT Investor Calls Checkmate on Highfields
The main argument with Highfields relates to valuation. In other words, the hedge fund believes that Digital has no margin of safety and that the company's moat is getting smaller, not larger. In the book Margin of Safety by Seth Klarman, the author explains:
Markets exist because of differences of opinion among investors. If securities could be valued precisely, there would be many fewer differences of opinion; market process would fluctuate less frequently, and trading activity would diminish. To fundamentally oriented investors, the value of a security to the buyer must be greater than the price paid, and the value to the seller must be less, or no transaction would take place. The discrepancy between the buyer's and the seller's perceptions of value can result from such factors as differences in assumptions regarding the future, different intended uses for the asset, and differences in the discount rates applied. Every asset being bought and sold this has a possible range of values bounded by the value to the buyer and the value to the seller, the actual transaction price will be somewhere in between.
As any current or future investor in Digital Realty knows, the key to sleeping well at night is to own shares with an adequate margin of safety. The most important thing is to exercise discipline and move to purchase when there is an element of BARGAIN. Seth Klarman explains the importance of the margin of safety:
Value investing combines the conservative analysis of underlying value with the requisite discipline and patience to buy only when a sufficient discount from that value is available. The number of available bargains varies, and the gap between the price and value of any given security cab be very narrow or extremely wide…such persistence is necessary, however, since value is often well hidden.
So how wide (or small) is Digital's Moat Today?
Digital Realty was a pioneer in the data center industry and accordingly the San Francisco-based REIT enjoys a "first mover" advantage. Digital started out as a private equity fund (GI Partners Fund I) in 2001 and later became public in November 2004. During nine years as a public REIT, Digital has built out a dominating global footprint that provides for tremendous competitive advantage as it relates to supply chain management and balance sheet management.
With over 122 properties (22.7 million rentable square feet), Digital has a diversified portfolio of properties and tenants that span North America, Europe, Asia, and Australia. Digital's "wide moat" diversification provides for a well-balanced tenant operating platform.
Digital has a high-quality tenant base with approximately 2,000 leases with over 550 tenants, including leading global companies across various industries. No single tenant accounts for more than 9.1% of Digital's annualized rent.
Another feature of Digital's "wide moat" model is its "3 bucket" operating model that consists of (1) collocation & cloud, managed service providers (2) corporate enterprise users, and (3) International network & telecom providers.
As part of Highfields' short thesis, the hedge fund claims that Digital has a risk of competition from technology giants such as Amazon (NASDAQ:AMZN), Microsoft (NASDAQ:MSFT), and Google (NASDAQ:GOOG). However, in a WSJ blog, Digital' CEO, Mike Foust explained:
We don't see ourselves as competing with a Google or Amazon. In fact, everyone is benefiting from the growth in … cloud whether Google builds its own data centers or whether [people] choose to outsource their facility with Digital Realty. We have one of the strongest balance sheets in the real estate industry and we're providing a very strong dividend coverage and consistent earnings growth over the year. We expect that to continue.
Based upon historical NOI growth, I would say that Digital has been able to provide very stable and reliable revenue. Clearly Digital has been the "go to" exit strategy for many data sector private equity landlords and with over $4.9 billion of acquisitions closed since 2005, the well-balanced REIT has become a true "consolidator" of data storage facilities.
In addition, the data storage sector produces "juicier" returns than many of the other sectors and that makes the investment opportunities even more attractive. Because of Digital's access to capital and its global footprint, Digital is able to achieve better returns, another key differentiator for Digital's cash flow stability.
2012 was a record breaking year for Digital's acquisition team. The company closed on over $1.53 billion (in 2012), almost triple the average volume since 2005.
Part of Digital's multi-pronged growth strategy has been its high-quality cash flows balanced by very stable lease roll-overs, and one of the most important things to know about data storage is that it is very expensive for a tenant to move out of a facility. That makes the lease renewals easier for data landlords like Digital. Also, most leases have built-in contractual lease increases and a majority (71% for DLR) have non-utility expense pass-throughs. Also, tenants are responsible for power costs. Here is a snapshot of Digital's well-laddered lease expirations:
Clearly the highly capital-intensive facilities also provide Digital with significant barriers to exit. Accordingly, Digital's high tenant retention and stable occupancy has resulted in a very stable and reliable operating model. Here is a snapshot of Digital's durable same-store occupancy (>93% for the last 5 years):
Digital's proactive portfolio management has driven growth, cash flow stability and shareholder value. From 2005 through 2012, Digital has grown average compounded annual Adjusted EBITDA by 29%. In addition, Q1-13 Adjusted EBITDA was $212.6 million - up 23.6% from $172 million in Q1-12.
More importantly, Digital has grown its annual FFO per diluted share by 18.7% for the same period (2005-2012) and Q1-13 core FFO increased by 11.3% from $1.06 (Q1-12) to $1.18 (Q1-13).
The Stupidest Argument
I think the stupidest assertion by Highfields is the claim that Digital relies on access to capital markets to fund its dividend and that the dividend is not sustainable. Wow, what nonsense.
Digital increased the 2013 dividend by 6.8% over 2012 and the well-capitalized REIT has increased its annual dividend for nine years in a row. Also, Digital has increased its dividend by an average of 15.3% (from 2005-2013). With a healthy AFFO payout ratio of 84.1% (Q1-13), Digital has become a dream for many SWAN (sleep well at night) investors.
Digital has an investment grade balance sheet (S&P/BBB) with conservative leverage ratios consisting of 33.6% total debt to total enterprise value and 5.2x net debt to LQA Adj. EBITDA. In addition, Digital has exceptionally strong coverage ratios that consist of 4.4x debt service coverage and 3.5x fixed charge coverage. Unsecured to total debt stands at 83.4% and the company has attractive well-staggered debt maturities.
Digital has an enterprise value of around $14.5 billion (as of April 30, 2013). Here is a snapshot of the current capital structure:
Highfields Capital is Wrong Because This Digital Cloud REIT Ain't Going Nowhere But Up
Last week my oldest daughter won a statewide essay contest. You won't believe what she wrote about. Let me just provide you with the last paragraph (source: Lauren Thomas essay on Digital Realty):
DLR is the clear leader in the data center sector, outperforming its competitors CoreSite Realty (NYSE:COR) and DuPont Fabros Technology (NYSE:DFT), and claiming the most market share with the highest dividend yield. DLR has a diversified tenant portfolio with acquisitions distributed worldwide, making the company well positioned to defend against possible interest rate increases. This tenant diversification should ultimately enable the company to protect itself against isolated risks associated from rising interest rates. In today's growing economy and given the increased demand for data storage, DLR is a clear winner for investors, providing long-term, durable and sustainable income.
Now, I will be the first to tell you that I'm proud of my daughter. She is graduating in three weeks and she has already enrolled at The University of North Carolina. I assure you that she had no help writing her paper other than a few articles that she read from me and others. It find it amazing that my daughter has demonstrated, at an early age, the necessary "traces of wisdom" that differentiate an investor from a speculator. As my daughter has also learned, Mr. Market is the product of the collective action of thousands of buyers and sellers (including Highfields) who themselves are not always motivated by investment fundamentals. Speculators like Highfields will inevitably lose money and investors who take advantage of Mr. Market's periodic irrationality have a good chance of winning.
In summary, it's time to jump on this cloud. Digital has a most attractive valuation of 13.6x and I consider the fundamentals sound. Driven by growing world-wide demand and a very high-quality tenant base, Digital has evolved into a best-in-class global data center platform. Digital's "first mover advantage" has allowed the REIT to build a commanding barrier-to-entry model in which its mere scale provides access to capital and strong expertise in the global cloud supply chain.
At $65.51, Digital is a BUY. Highfields must have mistook Digital for Rackspace (NYSE:RAX), which does have competition from Amazon and suffers (RAX is in managed hosting and clue services and is not a REIT). But thanks to Highfields' foolish short wager, I believe the shares have moved into the very attractive category (between fair value and a bargain).
Digital's current competitive position - it's economic moat - is solid and I believe that the advantage is sustainable and that will preserve long-term pricing power and profitability. It's rare in today's market but I think Digital represents a "wonderful buying opportunity at a most attractive price." The dividend (yielding 4.76%) is safe and I expect to see continued growth as consolidation continues for the growing cloud sector.
Sources: SNL Financial, FAST Graphs, DLR Investor Presentation (May 2013).