- Investors should learn to view avoiding losses as being the same thing as making a profit.
- At least some commercial real estate businesses are heading for trouble based on current valuations.
- My primary purpose when analyzing a stock is to find a reason not to buy it rather than trying to convince myself I should.
It just does not seem like it has been 6 years since the real estate market imploded and bankrupted millions of businesses and speculators who had driven up asset prices in the residential real estate market to absurd levels. The conventional "wisdom" at the time said that home prices had always moved higher and always would. The few people who tried to point out the unsustainable level of home prices and the dangerous amount of leverage that was driving them higher were generally derided as lacking the sophistication and intellect to grasp the "new reality" or simply of being tied to "old-fashioned thinking."
The new reality was putting a small down payment on a house under construction (or even pre-construction) and selling it to another buyer for a huge profit before it was even completed and livable. Prices of real estate soared. Prices of homebuilders soared. Prices of material suppliers and distributors soared. Then one day, it ended. At first, it was a few defaults as people were unable to sell homes they had agreed to buy as quickly as they had anticipated and they could not meet loan obligations. Then it was a few more. It did not take long for the entire house of cards built on the false assumption of ever-increasing home values to come to a disastrous but predictable end.
It is the nature of things to move from one extreme to another and it is the nature of capital to flow to where it is treated the best. However, capital flow is not usually fully efficient and that lack of efficiency allows the formation of bubbles that will, at some point burst. Those businesses or industries that fail to deliver decent returns on investors' capital will at some point either improve their performance and become a competitive investment vehicle or fall in value to the point that they are fairly priced to the level of performance they deliver.
Avoiding Risk Is Just Like Making a Profit
Successful investing is certainly about finding undervalued businesses or market sectors that are poised for big gains; but, it is also about avoiding businesses or sectors that are priced far beyond what is justified by the performance they deliver. If another business or industry sector fails to perform as well as others, eventually investors' capital will flow away from the poor performers and toward the leaders. Learning to identify poorly performing businesses and sectors so they can be avoided is just as valuable a skill as being able to pick winners. If you pick a stock that goes up in value, you end up with more money than with which you started. If you avoid buying a stock that goes down in value, you will have more money afterwards than if you had made the poor investment. Both are decisions that cause you to end up with more money than would otherwise have been the case.
Being a rather conservative soul when it comes to money, I prefer to avoid businesses that are highly priced or under-performing. When I find a group of businesses that meet both those criteria and are in the same general market sector, I not only step back, I run and run far.
It's Different This Time
One of the classic responses from people who have money in sectors or businesses that are severely overvalued when the condition is pointed out to them is to respond that: "This is different!" Normally I just chuckle. However, this time it is different, this time it is not residential real estate, it is the commercial segment that appears to be building to a bad conclusion.
In reviewing a stock screen of businesses that are potentially overvalued in relationship to the results they are producing, I noticed that an extraordinary number of the names contained a reference to real estate. Upon closer scrutiny, it became apparent that all of the real estate businesses shown were tied to the commercial real estate market.
SL Green Realty Corp. (NYSE: SLG), Kilroy Realty Corp. (NYSE: KRC), Kimco Realty Corp. (NYSE: KIM), Eastgroup Properties, Inc. (NYSE: EGP) and Federal Realty Investment Trust (NYSE: FRT) were all names that appeared on my screen.
A quick glance at some basic financial metrics reveals that even in areas where these businesses might appear to be attractive investments, the truth is somewhat different at this time. These stocks all have dividend yields of at least 1.52% (SL Green) and range up to a yield of 3.93% for Kimco Realty. Unfortunately, SL Green has the lowest payout ratio of the group at a substantial 73.63% of earnings and the rest of the list has payout ratios well over 100%. It is highly questionable as to whether these payout levels are sustainable.
All of these businesses are heavily burdened with debt and carry debt to equity ratios from 92% for Kilroy to as high as 199% for Eastgroup Properties. Interest payments on debt must be covered through operating income and it is important to have sufficient income to cover interest payments comfortably. Once again, all of these businesses fall well short of what most would consider a comfortable level of coverage with a range of 1.37 times for Kilroy Realty to a best of only 2.42 times for Federal Realty.
The numbers don't get much better when it comes to how management has performed with investors' money either, as indicated by the table below showing the 5-year average returns in three critical areas.
*ROE= Return on Equity; ROA= Return on Assets; ROC= Return on Capital. All data in the table was sourced from MSN Money.
These are not the kind of numbers that I would be proud of if it were my money and it would be if I were a shareholder in one of these businesses.
Investing Is About the Future
However, even businesses that have performed poorly over the past five years can be interesting destinations for capital if they are priced fairly and have good prospects for future growth of earnings. Let's face it, the past is not always indicative of future performance. It is also possible for a business to be priced low enough to be attractive even with prospects that are below average.
Once again, as indicated by the table below, that is not the case for these five businesses either. This table shows the actual price to earnings ratio for 2013 and the projected P/E ratios based on the average earnings projected by analysts for 2014 and 2015 as well as the projected earnings growth rate for the next five years. The PEG ratio shown is the result of dividing the projected price to earnings ratio for 2014 by the 5-year projected earnings growth rate. Usually, a ratio of 1 is considered to be fair value except in the case of fast growing businesses.
*All data in the table was sourced from MSN Money.
So, here we have a list of businesses that have not only performed rather poorly over the last five years in terms of real shareholder value created; these businesses are also very highly valued in terms of their price to current and forward projected performance.
Most investors I know who perform their own analysis do so in search of reasons to buy a particular stock. I take the opposite approach. When I find potential candidates for capital allocation, my analysis is performed for the purpose of finding a reason not to buy it. In the case of these five businesses and quite possibly many in the commercial real estate sector, I did not have to look far to find out why to avoid them.