The Danger In Best Of Breed

by: Darren McCammon

Marquee names can have their own special risks.

Explaining the virtuous cycle.

Allocation still matters.

Ben Axler, a notable short analyst, pulled the trigger on Realty Income (O) today. I have no position and no intention of taking one, but admit to a bit of schadenfreude. More importantly I wanted to use this as an "educational moment" to talk about an additional risk inherent in such marque names.

Ben's main points regarding Realty Income include:

  • same store sales growth is inflated by excluding vacancies
  • insiders own nothing
  • the audit committee overseeing management is very weak
  • with interest rates rising, and organic growth now negative, it's hard to justify its industry leading valuation

However, it is later in the article where we get the educational moment which applies to best of breed names in general,

The Company is very dependent on issuing stock at inflated prices to fund its acquisitive growth strategy, keep its cost of capital low, and consistently raise its dividend. The model has worked well for years when times were good, but we believe this magic cycle is about to break down...

This should sound familiar, it is the same strategy many companies have successfully used for years. Cisco (CSCO) pioneered it back in the 90's, namely use high priced shares as a currency to build value underneath you. MLPs relied on another version of it to build out pipeline infrastructure, until the oil crash broke the faith. The Virtuous Cycle Formula is basically:

  1. Convince investors you are worth 1.5x
  2. Sell shares at those high multiples
  3. Leverage it up as cheaply as possible
  4. Use the cash from both shares sales and leverage to buy assets at 1x
  5. Rinse and repeat
  6. Growth is the result, helping to perpetuate the virtuous cycle

Honestly, it is a great strategy that has built some truly great companies. You are just using your ability to print shares, and investor faith in those shares, to buy or build actual value. That real value then underpins the shares. It helps if your CEO is a good showman, and / or you have actually trademarked the phrase, “The Monthly Dividend Company®”.

The danger however is it only works as long as those shares are highly valued. If faith in that value is punctured, so to is the high multiple and therefore the ability to trade something at 1.5x for something at 1x. When you can no longer do that, the ability to produce growth disappears right alongside the devaluation. Essentially it works, until it doesn't, with Amazon (AMZN) and Tesla (TSLA) defying my expectations as to how long management can keep it going. But at least in the case of AMZN and TSLA, investors realize they are buying into a highly priced growth stock. When it crashes one day, those who have been in long enough, will likely still be way ahead.

What concerns me more is a number of Seeking Alpha income favorites also benefit significantly from this model. Like O 'the premier equity REIT', BXMT is considered 'the marquee commercial REIT', and MAIN 'the best BDC'. These are good companies which are ran well. They do have advantages. However, like O, they also depend on an ability to sell shares at higher multiples than competition, plus cheap leverage, to support growth. Thus they are every bit as susceptible to a bubble prick as Realty Income.

In the case of pass-through securities, not only does a lot of the growth come from selling shares at high price to NAV ratios, but it is also a significant reason some enjoy lower costs of capital than others. Thus, not just the income growth, but also the higher spread, is a direct result of the higher multiple. There is nothing wrong with this, it is in an existing investors best interest for a company to sell high priced shares and buy lower priced assets. In general you also want your company to access and leverage cheap debt.

What concerns me is not so much the companies actions, but rather the particularly high regard some income oriented investors place upon them. I am not sure these investors realize virtuous cycles can break, or even that they are buying into one. If they do not realize the risk, they may invest too much in that special "best of breed" name.

I think it OK for a 20 or 30 something to put 15% of their investable net worth in TSLA or AMZN. They have less of their overall lifetime wealth invested, and a greater ability to recover. A 60 or 70 something income investor on the other hand, is a different matter. For them, putting a double digit percentage of net worth into MAIN, BXMT, or O is unwise. Again, the point is not to dig BXMT, MAIN, or O as a company, or even their management, but rather to help investors realize their "trust" is actually placed in a virtuous cycle continuing. Their trust in large part, is in management's ability to keep the faith of the other investors just like themselves. If other investors ever decide the company just isn't worth the high valuation, there's not a whole lot management can do about it.

Well except, maybe launched their product into space......

By all means invest in Best of Breed names, just don't break your allocation rules when doing it.

You do have allocation rules don't you?

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Additional disclosure: This post mentions risky investments. The author does not know your goals, risk tolerance, or particular situation; therefore, he can not recommend any specific investment to you. Please do your own additional due diligence.