I use the term market dynamics to refer to the factors influencing the supply and demand of a stock. They have no bearing on the intrinsic value of the company, but they can drastically influence the market pricing of a stock. When market dynamics are balanced, a stock will tend to trade near its intrinsic value. In this article, we will be focusing on the supply side and reveal a current opportunity.
Economics 101 tells us that a supply choke will cause the price of a stock to rise. Quite simply, some people want to buy the stock but there are not enough shares available, so prices rise until the market reaches equilibrium. If one can identify a supply-choked stock before the price rise, it can be an excellent opportunity. Here are factors that often cause supply chokes:
- Share lock-ups
- Passive investors
In a baseline scenario, both supply and demand for shares should be roughly correlated with market capitalization. Bigger stocks have small bid/ask spreads as there are ample shares available on each side. However, the aforementioned factors can prevent supply of shares from properly correlating with market cap.
When GoPro (NASDAQ:GPRO) IPOed a few years ago, it had a truly massive share lockup, which caused its public float to be a small fraction of the market cap. This caused its price to spike from an IPO just under $40 to above $90.
Demand for shares was normal, so the 100% of normal demand overwhelmed the minimal supply without regard to fundamentals. The situation was such that a majority of those looking at GPRO could pass on it due to valuation, but as long as some shares were in demand, it was enough to push the stock higher.
Fast forward a couple of years and the lockup expires causing the supply to normalize. GPRO swiftly dropped closer to its fundamental value as market dynamics were no longer supporting the price.
The remaining 3 sources of supply chokes are related in that they all represent investors who buy and hold the shares in an inelastic fashion.
Passive investors are in this instance representing those who are not all that focused on their investment. This would be your uncle who bought shares of a stock 15 years ago and occasionally looks at it but never actually consummates a trade. Most stocks have some passive investors, but it does not cause a supply choke unless the concentration is too high.
Just over 2 years ago, I wrote a short thesis on Apple Hospitality REIT (NYSE:APLE). It was overvalued and the hotel environment was getting a bit difficult. To this day, I still think I was right about the fundamentals, but it was a bad trade because I failed to consider the market dynamics.
Even as hotel REITs tanked, APLE floated with impunity. Its fundamental performance was no different than peers, but there was a supply choke from a massive accumulation of passive investors.
APLE was formerly a non-traded REIT that gobbled up related non-traded REITs. I suspect many of the investors who owned APLE at its IPO did not yet know that it was a publicly traded stock. They got their dividend check in the mail and that was that. As such, there was minimal supply of shares. The float was functionally constrained by the large portion of shares held by those who would not sell regardless of price.
Accumulators and ETFs
Most accumulators self-identify as buy and hold investors and they often DRIP. Those who were successful with this strategy are sitting on a sizable capital gain that would threaten tax consequences if the position is ever sold. This only furthers the stickiness of investment.
Major ETFs have historically been extremely sticky with inflows consistently outpacing outflows over any long stretch of time. Since the market share of ETFs has consistently risen, this sticky money now makes up a large portion of many stocks.
All 4 sources of supply choke stack summatively, so if a stock has 15% of shares locked out, 10% passively owned and 30% in ETFs, it is functionally choked by 55%. Such a sum is sufficient to make its market price somewhat inelastic with respect to underlying fundamentals. Often, it is not quite as quantifiable as only the ETFs and lock-ups are published data. Spotting accumulators and passive investors is more of a judgement call.
Supply choke opportunity
Global Net Lease (NYSE:GNL) is among the cheapest NNN REITs with a 2017 FFO multiple of only 10.3X, and it is on the brink of a supply choke, which should send shares up materially.
GNL was initially a non-traded REIT so we suspect there are still remnants of its shareholder base that are passive investors. This was recently bolstered by the purchase of its non-traded REIT brother Global II. This purchase simultaneously created and delayed the supply choke in that it likely brought on a significant number of additional passive investors, but it also provided liquidity for those who wanted to get out. Thus, in the short time window after acquisition, supply was likely increased, but once those who desire liquidity get out, it will be left with a larger share of passive investors for the medium term.
On top of the passive share, GNL is now of sufficient size to be included in the major ETFs and passive mutual funds. Between its top 4 holders, we estimate about 25% is held in a price inelastic manner.
Finally, we suspect GNL has a significant number of accumulator type investors as it has many of the characteristics that group looks for.
- Big dividend yield at 9.4%
- High fundamental visibility with a very long remaining lease term
- High portion of investment grade tenants
- Reasonably low leverage
Obviously, we cannot quantify the accumulators and passive investors, but we suspect it has become a sizable share. Added to the ETFs, we think there is a material chance of a supply choke sending shares much higher. Our fundamental analysis, linked here, also suggests material upside. It is not often that fundamentals line up with market dynamics, both suggesting a buy.
Market dynamics are worth considering as they can explain previous pricing movements and when used well, can hint at future trends. We would never suggest using market dynamics in isolation, but when used in tandem with fundamental analysis, it can potentially enhance alpha.
Disclaimer: 2nd Market capital and its affiliated accounts are long GNL. I am personally long GNL. 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. Investing in publicly held securities is speculative and involves risk, including the possible loss of principal. The reader must determine whether any investment is suitable and accepts responsibility for their investment decisions. Dane Bowler is an investment advisor representative of 2MCAC, a Wisconsin registered investment advisor. Commentary may contain forward looking statements, which are by definition uncertain. Actual results may differ materially from our forecasts or estimations, and 2MCAC cannot be held liable for the use of and reliance upon the opinions, estimates, forecasts and findings in this article.
Disclosure: I am/we are long GNL.
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.