Benjamin Graham and Warren Buffett have referred to a neurotic rascal named "Mr. Market" and have noted that he is whimsical and fickle in exercising his responsibility to set equity prices. Mr. Market is, in fact, very different indeed from his staid, boring, mathematical twin who lives only in the Efficient Market Theory and not in the real world. At any rate, the real Mr. Market periodically provides us with bargains and an important part of investment strategy is to be respectful of Mr. Market and to accept his generosity when it is extended to us but not to be persuaded by his emotional attitude toward equity valuation.
In looking for this year's Christmas presents from Mr. Market, I tried to find stocks with three key characteristics - 1. undervaluation based on a persuasive metric, 2. downside protection, and 3. substantial potential for massive appreciation. In this regard, the two names that jump to the top of the list are American Capital (ACAS) and Lexington Realty Trust (LXP). Both of these stocks satisfy these criteria and are "back up the truck" bargains at current prices.
1. Lexington Realty Trust - LXP closed Monday at $10.24 a share and pays a 66 cent a share dividend for a yield of 6.3%. I believe that the stock is likely worth at least $15 a share. I have become a fan of the net lease real estate investment trusts (REITs) for a number of reasons explained in more detail in an earlier article.
A. The Metric - I have developed a metric for evaluating stocks in the net lease sector which I believe captures underlying value. First of all, I use enterprise value rather than market cap. In calculating enterprise value, I add net debt (total debt minus balance sheet cash and owned loans), preferred stock and the value of non-controlling interests to market cap. I believe enterprise value is a better metric than market cap because it takes away the distortion that tends to favor leveraged companies in the current interest rate environment. A company that it is underleveraged can decide to become leveraged; it is not always so easy to move in the opposite direction. I then calculate annual gross rent by multiplying the most recent quarterly rent total by 4. I do not try to calculate expenses because we are dealing with net lease REITs and almost all expenses are paid by tenants. In some cases, there is a reimbursement process and, in a given quarter, reimbursements may distort financial results. I use the most recent quarter because these companies are frequently acquiring and disposing of properties and a full year will contain substantial periods of time in which rent was generated by properties which are no longer owned and in which recently acquired properties did not generate rent. Since we are looking at a "snapshot" of debt and market cap by looking at the results as of the close of the most recent quarter, we should try to do the same thing with rent. The metric, then, is enterprise value as a multiple of gross rent or EV/GR.
B. LXP's EV/GR - Applying this metric to LXP as of the close of the most recent quarter (September 30, 2013), I get total debt, preferred stock and non-controlling interests of $1.943 billion and total cash and owned loans of $204 million producing net debt of $1.74 billion. Market Cap at Monday's closing price using September 30 share count is $2.21 billion; thus, enterprise value is $3.95 billion. Gross rent is $90 million a quarter or an annual $ 360 million. As a result EV/GR is just a shade under 11.
C. Comparative EV/GR's - I have tried to calculate EV/GR's for other companies in the sector. In this regard, I have made the calculation for Realty Income (O) and National Retail Properties (NNN). I have also calculated the EV/GR that applied to CapLease (LSE) when it was acquired earlier this year because that is a measure of the private market value of these companies. The Table below includes this data as well as providing the share price LXP would command if it traded at a more reasonable EV/GR of 15.5.
It should be noted that the percentage increase in the price exceeds the percentage increase in the EV/GR because of leverage. Based on this metric, LXP appears to be undervalued and very attractive at the current price.
D. Issues and Risks - One of the biggest problems with this (and almost any other) methodology is its "snapshot" quality. For example, in the case of LXP, there have been changes in debt, assets, total rent, and even share count since September 30. I do not see any of these as being significant enough to undermine the analysis. Shares were sold in early November for $11.17 but this suggests that the current price is a bargain. One large asset acquisition came in at a multiple of roughly 20 but it has built in escalation clauses and automatic rent increases and it constitutes less than 5% of annual rent income. Ideally, a pro forma could be prepared but this would present other problems. Reviewing the scale of the post September 30 transactions, I do not think that they change the fundamental analysis significantly. In assessing risks, we have to consider interest rates. LXP is relatively underleveraged so it would take less of a hit than other players in the sector. Most leases escalate (at least partially) with inflation and interest rates are unlikely to increase dramatically unless there is significant inflation. LXP is certainly a better bet than anything in the fixed income sector because of its ability to increase income with inflation. On balance, I think that the stock could pull back with a sharp uptick in interest rates, but, if it does, that will likely present an attractive entry point.
E. Conclusion - I am satisfied that LXP is undervalued based on a persuasive metric. It has recently delivered a presentation which shows that it is undervalued based on the funds from operations (FFO) metric as well. This confirms the accuracy of the analysis. LXP has a substantial upside. If it moves up to an EV/GR multiple more in line with the rest of the sector, its price could shoot up as much as 70%. Downside protection is provided by a secure 6.3% dividend and a relatively low payout ratio. Thank you, Mr. Market, I am sorry that I forgot to get you a gift this year but I will try to remember you next year.
2. American Capital - I have written about American Capital before and recommended it at various points along its ascent from the nether regions below $2 a share to its current price of $14.64. My most recent article advises buying it, if possible, whenever it trades below $13.33. ACAS is a business development company (BDC) but as explained in a recent presentation, it has become more of conglomerate, owning both equity and debt in its own portfolio companies instead of following the usual BDC practice of providing financing to non-portfolio party companies. My recent article describes the steady increase in both net asset value (NAV) and share price in ACAS since 2009. Once again, ACAS is selling at a large discount to NAV and is a compelling investment at this price.
A. The Metric - The metric I use for BDC's P/NAV or price as a percentage of net asset value. I generally look for discounts of at least 10% and back up the truck when discounts exceed 25%. In employing this metric, one must be mindful of leverage. Because of leverage limitations, BDCs with too much debt can be forced to sell off assets at bargain prices. Thus, I try to stay away from any BDC whose debt is 40% or more of total assets (the maximum is 50%). ACAS had an NAV of $19.54 as of the close of the last reporting period (September 30, 2013). I believe that two adjustments are appropriate. First of all, as described in the above presentation ACAS is carrying one of its subsidiaries at a discount of $214 million to that subsidiary's own NAV. Marking this asset up to actual NAV increases total NAV by 77 cents a share. Secondly, ACAS has been steadily increasing NAV since 2009 and this increase has been consistent (perhaps in part because it is supported by a share repurchase plan). Based on past percentage increases and current NAV, a $2 annual increase or 50 cent a quarter increase would be a very reasonable projection. Given that we are almost 3 months after the close of the last quarter, an upward adjustment of 40 cents a share is very reasonable. This gets us to $20.71 a share of estimated current NAV which suggests that the stock is trading at a 29 percent discount to NAV. I do not believe that there is any BDC (with the possible exception of very, very small BDCs) that is trading at close to this discount.
B. Problems - Whenever I write about ACAS, the comments provide a very good summary of the negatives. In the early days, there were lots of investors who lost a huge amount of money in the precipitous 2008-2009 decline. Today, there are investors who are concerned about interest rate exposure, the lack of dividends, and the transparency of portfolio companies. ACAS is often confused with American Capital Agency (AGNC) which is sensitive to interest rate changes. ACAS owns American Capital Asset Management (ACAM) which manages AGNC and earns fees in the process; ACAS does not own AGNC. On the other hand, increases in interest rates can adversely affect ACAM by reducing the profits of AGNC and thereby reducing ACAM's management fees. There can also be an effect on assets under management, as higher interest rates lead to a reduction in leverage and, thus, in total assets under management. Indeed, in the most recent quarter ACAS wrote down ACAM on its balance sheet and this led to a smaller than normal increase in total NAV. ACAM could be subject to additional write downs but ACAM manages assets other than AGNC and ACAM is now valued very, very conservatively based on cash flow. A lot of bad news has been priced in. The second concern - the lack of dividends - may make it difficult for ACAS to close the gap with NAV. Corporate policy seems to be the use cash for share repurchases rather than dividends as long as the stock is priced below NAV; this may result in a kind of "self-fulfilling prediction" as dividends are actually one of the things that might lead the stock to trade at or above NAV. The last point (about the transparency of portfolio companies) is a legitimate one. ACAS discloses a great deal of information about portfolio companies, but there are a great many of them and it is difficult to do anything but trust valuations. When companies are sold, an investor can observe the sales price and discover whether past valuations were accurate. ACAS looks very good in this regard, but it is likely that the more successful portfolio companies are the ones likely to be sold and so they do not constitute a random sample. ACAS appears to be taking steps to increase transparency as described in the above linked presentation.
C. Conclusion - I am not sure whether I would be willing to pay $20.71 for ACAS but at $14.64, it is a compelling bargain. A lot of things can go wrong before the NAV would be driven down to the current stock price and ACAS is generating impressive cash flow so that the asset depreciation would be offset by cash accumulation. My baseline scenario here is for the NAV to increase by roughly 10% a year ($2 a share at the current level) and for the share price to continue trailing NAV at a range between 10 and 30 per cent. The current discount is near the high end of the range and so an investor here can benefit from both higher NAV and a reduction in the discount. The big upside is a catalyst which eliminates the discount; the most likely candidates are the declaration of dividends, a takeover or a restructuring. I do not think that there is a great deal of downside at this price level because we are at the high end of the discount range. Thanks again, Mr. Market. Next year, we will leave something very nice under your tree!