Realty Income (NYSE:O) has become one of the most discussed securities with constant verbal pugilism between the diehard fans and those who think it is dangerously overvalued. Recently, however, there has been a change in the public discourse. Specifically, the bulls are starting to agree with the shorts that O is overvalued, but here is the kicker, they stay long anyway. Essentially, as Realty Income has continued to see rapid appreciation in its market price, the bull thesis has morphed roughly into the following.
New Bull Thesis
Realty Income has increased its dividend for years and will continue to increase it reliably for the foreseeable future. Therefore, a long term investor will collect a rising stream of dividends even if O is expensive in traditional metrics such as P/FFO or net asset value.
This part I agree with. The fundamental analysis on O that most of us are familiar with suggests it is a very sound company that is run in such a way that it can continue to increase its cashflows and therefore the dividend. I have done my own fundamental analysis on O and largely agree. Realty Income is a very well-run company that is likely to grow slowly and consistently over time which should in fact fuel rising dividends.
However, a rising stream of dividends is not single handedly a reason to buy or hold a stock. Thus, the bull thesis requires a second clause which is generally along the lines of O's fundamentals protecting shareholder value. Whether it is in reference to the conservative nature of O's balance sheet or its diversification or its high quality tenants or strong management, the end point of the thesis is the same - Sturdy fundamentals will protect the investor's principle.
This part seems to be true. It appeals to fundamental analysis in that all of those things do in fact promote safety. Unfortunately there is a logical flaw in such an assessment. Those fundamental factors serve to protect the value of the ASSET, not the value of the investor's principle.
A warning for DGI investors
I have become increasingly concerned that a large group of investors who believe they are investing responsibly will lose a very large portion of their money. There seems to be a widespread belief that a low risk asset equates to a low risk stock.
Imagine a perfectly riskless asset; one with fundamentals so robust that it cannot lose value. Such an asset still has finite value and whatever that finite value happens to be equals the price at which is it an extremely safe buy. However, to the extent that price positively deviates from the intrinsic value, a new variable of risk is introduced to the perfectly riskless asset. If the market price is at a 50% premium to the intrinsic value of a perfectly riskless asset, an investor can lose 50% of his/her money despite the asset being perfectly riskless.
Therefore, a perfectly riskless asset does NOT translate to a low risk stock in situations where the price deviates from intrinsic value.
This is the case with Realty Income. It trades at such a massive premium to its intrinsic value that it is actually a very risky stock. If we use NAV as a guide, we can see that O trades at a 45.9% premium to NAV.
The underlying assets are worth about $47.66 (according to a consensus of 10 sellside analysts) while the stock trades at nearly $70 per share.
I would argue that the actual value of its assets is even lower since the cap rate used to derive the $47.66 NAV is quite aggressive. 5.92% is a very low cap rate for a bunch of Taco Bells and Walgreens.
Using a more realistic cap rate, the value of O's assets is closer to $40, but for the sake of conservative analysis, I will use the sell-side analysts' more bullish NAV.
Principle is at risk - the intrinsic value is safe but the premium isn't
The strong fundamentals which we discussed above are very likely to maintain O's asset value. We do not see significant vacancy or tenant defaults. O is reasonably similar to the figurative riskless asset. Such an asset is great for investors seeking safety if and only if it is bought at or below intrinsic value. Unfortunately, O is a low risk asset worth $47.66 that is being bought for nearly $70.
The portion of an investor's principle that is protected by the asset is safe, but the $20+ of premium is not. Realty Income is up about 50% in the past 52 weeks.
Over this same time period, its FFO/share has only increased by a mere 3.3% (2015 to 2016).
With such a massive price movement, a dislocation has formed between the asset value and the market price.
Presently, the market price is being supported by an unusual global economic situation in which nearly 0% treasury yields are driving investors into "safe" dividend stocks. It could last for a while or it could resolve quickly. There is no prevailing consensus among economists and I believe it is fair to suggest that the global macro environment is uncertain.
Given that the 40%+ premium on O shares over their intrinsic value is contingent upon the maintenance of ZIRP by Draghi, Abe and Yellen, it is firmly in the realm of speculative investing. Any stock that can lose 40% of its value in a mere return to a normal economic environment is not the safe stock O is touted to be.
Warning in a nutshell
If readers only take home one point, I want it to be this: Realty Income has tremendous safety of asset value but this does not translate to safety of investor principle when it is purchased at a massive premium to NAV. This premium is contingent on a fragile macro-economic environment and could dissipate as quickly as it arrived. Investors who care about preservation of capital should give serious thought to selling.
Disclosure: 2nd Market Capital is short O in a small quantity. I am personally short O. This article is for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer.
Disclosure: I am/we are short O.
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.