Greed is good. Some of you might remember the phrase being said by Gordon Gekko, the Wall Street villain played by Michael Douglas in the 1987 film, "Wall Street." The actual phrase was much longer:
Greed, for lack of a better word, is good. Greed is right. Greed works. Greed clarifies, cuts through, and captures, the essence of the evolutionary spirit. Greed, in all of its forms; greed for life, for money, for love, knowledge, has marked the upward surge of mankind and greed, you mark my words, will not only save Teldar Paper, but that other malfunctioning corporation called the U.S.A.
Warren Buffett, another well-known, but less fictional character has another quote along those lines:
Be fearful when others are greedy and greedy when others are fearful.
Investors have been fearful of interest rate rises and have dumped REITs. We think it's a good time to be greedy.
Reversion to the Mean
Reversion to the mean is an often used term to describe an investment strategy that relies on long-term average performances for particular investments. The concept revolves around situations where returns on a particular security are either well below the long-term average or well above the long-term average. The strategy relies on extreme levels of metrics reverting back to a more normalized average, if you will.
Another way to use the reversion to the mean analysis in investment management is to analyze historical long-term average price ratios for a sector, industry, asset class, or security and determine if it's expensive or cheap relative to its long-term average. For example, Apple (AAPL) currently trades at a P/E of 12.4, and the other price multiples are shown in the table below. Apple's 5-year average P/E multiple is 15.2, indicating that Apple is currently trading at a discount to its historical 5-year average.
A reversion to the mean approach would indicate that over time, Apple should trade at a P/E multiple of 15. Whether that comes from multiple expansion or earnings declines warrants further analysis. The chart below, for example, shows the average price multiples for Apple over the last 10 years. The P/E multiple has steadily declined from 50.5 to 12.4 today, and the highest it's been in the last 5 years is 18. One might argue that the stock will eventually revert to a P/E of 15, but at least with Apple, the argument is not a very compelling one. If Apple does begin trading at a P/E of 15, the implied price would be $607 ($40.49 EPS x 15.2). Not a bad return considering it's currently selling at $500.
Reversion to the mean shouldn't be the only factor you should evaluate. In "The Art of Investing: How the World's Best Investors Beat the Market," Matthew McLennan of First Eagle Funds is quoted as saying:
At the heart of value investing is the notion of mean reversion, that by paying a low multiple on a conservative margin you can win with the passage of time as the valuation of the business and the margins normalize. What can break that can cause mean aversion, though, are things like fading business models, expeditionary management deploying capital in a dilutive way, and adverse capital-structure contingencies. We make every effort to invest only in the universe of companies where those risks of breakage are as limited as possible.
In any case, the reversion of the mean concept also stipulates that stocks that have outperformed for certain periods will tend to underperform in future periods, and vice-versa. In other words, losers become winners and winners become losers.
The chart below provided by Renaissance Macro shows an analysis of returns for the S&P 500 since 2000, indicating the performance of the top decile performers of the previous year, and comparing the subsequent month, 3-month, 6-month, and 1-year returns compared to the bottom decile performers of the previous year.
The results are compelling for the reversion to the mean argument. As the chart shows, companies that performed in the top decile, tended to underperform the companies in the bottom decile in subsequent 6-month and 1-year time periods. In other words, winners followed their performances by underperforming losers in the following 6-month and 1-year periods.
If this is the case and these results will repeat themselves, the outlook for REITs looks very attractive. REITs were one of 2013's biggest losers. On average, REITs gained just 2.9% in 2013, and that included an average dividend yield of 3.91%. That implies a price decline of about 1%, compared to a total return of 32%+ for the S&P 500. The worse performing REIT sectors were residential, healthcare, and residential mortgage REITs. Is that an indicator that they will outperform this year?
To further the point of the poor performance of REITs, only 28% of REITs are currently above their 200-day moving average, a clear indication of the sector's downward trend throughout the year.
The good news is that the bleeding looks like it may have stopped and at least in the short term, REITs may have started to turn the corner. 20-day highs have surpassed the 50% mark, which indicates some upward momentum in the sector.
But investors still seem to fear a repeat of the summer 2013 interest rate increases.
The Fear of Interest Rate Increases
Because of the dividend paying characteristics of REITs, they tend to be grouped in with fixed income investments when analyzing the impact of interest rate changes. While we did see a drop in REITs in the summer of 2013 when the expectations of Fed tapering were finally confirmed, over the long term, REITs have a relatively low correlation to interest rate changes.
Correlation of REITs to the change in 10-yr US Treasuries actually tends to be negative more often than not. The chart below shows the correlation of REITs to the 10-yr US Treasury from 2002 to January 2014. The area in green indicates time frames when REITs were positively correlated with Treasuries, while the area highlighted in pink, indicates negative correlation. Notice that correlations were negative until the summer of 2013, when it quickly spiked from a negative 0.2 to a positive 0.4. On an absolute basis, 0.4 is not a very high correlation, but the 0.6 change is quite dramatic.
In our view, this provides a certain level of comfort if interest rates do rise. However, the chart below indicates that 10-year yields may actually be at a level of resistance at about 2.8% to 2.9%. Since the date of the chart, the 10-year yield has actually fallen further to 2.7%.
But let's just suppose that rates do rise. May and June of 2013 notwithstanding, REITs tend to perform well in rising rate environments. The chart below highlights the last 4 years in which the Fed has raised rates more than three times. In each case, REITs outperformed both equities and government bonds and posted returns in excess of 25% in each year that the Fed had 5 or less rate increases. Even when the Fed increases rates 8 times in 2005, REITs still outperformed.
REITs as Long-Term Investments
A long-term investor looking to allocate to REITs should feel some comfort in the long-term potential of the asset class. The chart below shows 10-year annualized returns as of December 2013. The chart clearly indicates that Equity REITs outperformed both the S&P 500 and MSCI EAFE Index by over 100 bps. (Please note the chart is not drawn to scale)
Furthermore, REITs should be part of a well-diversified portfolio. The chart below indicates the returns on different asset classes for each year over the last 13 years. Unless you can identify and time the outperformance of each asset class, diversifying across each asset class shown would be prudent. As a point of fact, REITs led all asset classes in 6 of the 13 years!
If all of these factors hold true, this should be a great time to invest in REITs.
Investing in REITs
REITs can be evaluated by analyzing very similar metrics that one would analyze for investing in common equity.
Rationale - The first factor we look at when evaluating REITs is the rationale for investing in the space. For example, we could be investing in the secular trend of ageing baby boomers by gaining exposure to senior housing, which would benefit from an aging population and a need for assisted living facilities, nursing homes, etc. Or the increasing demand in mobile data usage due to gaming, videos, and music.
The company must also be well positioned in the space (i.e. Industry leader, niche market, etc.) and have a solid management team that can execute on the company's strategy.
Funds from Operations - Because of the accounting rules related to depreciation on real estate, REITs are analyzed better using a metric called Funds from Operations (FFO), which adds back depreciation and any gains/losses on sales or real estate in order to arrive at a 'better' indicator of a REIT's financial performance.
A REIT should have positive and growing FFO. The higher its FFO relative to peers or compared to prior years, the better the historical performance has been for that REIT. (historical performance not indicative of future results.) However, we would also like to see strong expected FFO growth in future years. These estimates may be provided by the company but should also be compared to available analyst estimates to determine if there is consensus on the future prospects for the company. If you are skilled at building valuation models on excel or otherwise can calculate your own future estimates of FFO, by all means it should be included in your assessment.
Dividend Growth and Payout Ratio - companies that have increased their dividends historically and are on track to continue to increase those dividends are more attractive than those with more sporadic dividend paying histories or unfavorable dividend policies. Typically, a REIT that is growing its FFO should be well positioned to increase dividends, so long as operating expenses are kept under control.
In any case, it is important to also evaluate the payout ratio of dividends to FFO to determine the sustainability of dividends in the future. A REIT that is paying out a large percentage of FFO, say 90%, may not have enough cushion to have a bad year and maintain its dividend. A REIT with a payout ratio that is lower has a safety net for sustaining its dividend and more flexibility in raising its dividend in future years.
FFO Multiples - Finally, you want to look for REITs whose Price/FFO multiples are relatively attractive. This can be measured in several ways. For example, P/FFO can be compared to future growth of FFO or relative to the long-term average multiple of the REIT. (see reversion to mean section above) Or, the P/FFO can also be compared relative to peers to determine if the market is applying a premium or discount to the REIT relative to peers. Don't be surprised if some REITs are always trading at Price/FFO levels above their peers. This indicates that the market views this REIT as more attractive in some regard, such as better management and execution, a more attractive niche, a stronger financial position, or any one of a number of factors. If this is the case, the relative premium/discount to be evaluated against its historical average.
Four REITs passed our Criteria
If you are looking to invest in REITs, we found four of them that are poised to take advantage of several cyclical and secular trends.
American Tower Corp. (AMT) - one of the largest cell tower owners in the US and Internationally. American Tower has grown its dividend from $0.35 in 2011, to $0.90 in 2012, and $1.10 in 2013. It currently has a dividend yield of 1.4% and the potential to increase it as FFO continues to grow in the double digits. At a Price/FFO multiple of 21.6, it is the priciest of the four but it has the lowest payout ratio at just 30%. (Read more about American Tower)
Ventas (VTR) - one of the largest senior housing owners and operators. It grew FFO just 9% in 2013, but with a dividend yield of 4.5%, and a Price/FFO multiple of 15, it looks good. (Read more about Ventas)
Weyerhaeuser (WY) - is driven by housing and international consumer demand for items made of fluff pulp, such as diapers and feminine hygiene products. It has increased its dividend from $0.60 in 2011 to $0.81 in 2013. The dividend yield is still low but was increased 31% in 2013. Expect more dividend increases until it is more in line with timber REIT peers. (Read more about Weyerhaeuser)
Host Hotels and Resorts (HST) - Host is the largest hotel REIT in the US, owner of over 100 upper upscale properties in the US and internationally. It has shown the most aggressive dividend growth, increasing its dividend from $0.14 in 2011 to $0.46 in 2013. At a Price/FFO multiple of 14.4 and a 2013 dividend growth of 53%, more upside surprises could be in store for Host. (Read more about Host Hotels)
Be Greedy When Others Are Fearful
It's sometimes difficult to be a contrarian investor and invest in something that the market is shying away from. However, as many successful investors can attest to, the best opportunities are often found in other people's trash. REITs have been mistakenly grouped together with other fixed income investments during discussions about the risks of interest rate increases. (The proverbial throwing out the baby with the bath water scenario) However, as we have outlined here, we think there are some compelling opportunities in the REIT space. You should do your own due diligence before making any investment decisions, but in this space, it might pay to be greedy.
Sources: Morningstar.com, Neuberger Berman, Renaissance Macro Research, NAREIT