ETFs continue to distort the market with an ever increasing passive share that is agnostic to pricing. Generally, they buy continuously at a slow pace as inflows come in, but there are certain points of time at which the buying is more rapid and can really move stock prices. One such time is the inclusion of a new stock into the index. Today I want to discuss 3 companies that are on the cusp of being added to a massive REIT ETF which I think will make their stocks pop.
The Vanguard Real Estate ETF (NYSEARCA:VNQ) has had $5.187B inflows in the last 52 weeks.
This takes its total size to a whopping $81.2B
ETFs have been having a massive impact on market prices of stocks for a while and as these ETFs get bigger the impact becomes even more pronounced.
Broadstone Net Lease (BNL) was added to the VNQ earlier this year and now Vanguard owns 13.73% of outstanding shares.
This indiscriminate buying of $565 million worth of the stock, in combination with the fundamental undervaluation, caused the market price of BNL to jump up.
This is the inherent problem with ETFs in the market. When large volumes of a stock are bought simply because a stock is added to an index and the shares are bought in a fashion that is agnostic to price, it impacts market pricing quite significantly.
While I believe ETFs making up such a massive market share is unhealthy for the stock market as a whole, it does create an opportunity that we can exploit. In hindsight, the opportunity with BNL was fairly obvious: An undervalued company with quality assets about to be added to a massive index.
Going forward there are similar opportunities regarding inclusion in the VNQ.
Shown below are equity REITs below $1B in market cap and those shaded in blue are already in the VNQ.
Source: SNL Financial and Vanguard
The inclusion criteria seem to be any equity REIT with a market cap over approximately $550 million. Franklin Street (FSP) and Chatham Lodging (CLDT) are functionally grandfathered in because they used to have a market cap over $550 million. Otherwise, just about every REIT of that size with a reasonable percentage of float is in the VNQ with a couple notable exceptions.
Thus, the rules for inclusion are quite straight forward. A company simply needs to be big enough and fully established as a REIT at the time of rebalancing and it will be added to the VNQ.
Plymouth is very likely to be added soon, while INDUS is on the bubble in terms of size so it might need to grow just slightly to be included.
The MSCI US IMI Real Estate index which the VNQ tracks is updated quarterly at the end of February, May, August, and November as seen below.
While being added to the VNQ is a great catalyst, I don’t view that as sufficient to justify investment. What I am really looking for is a great fundamental investment that also happens to have this catalyst.
Overall, I see 3 of these opportunities.
Significantly undervalued stocks with VNQ inclusion catalyst
As per the individual articles, I am bullish on the fundamental prospects of each of these companies but today’s focus is going to be on the specific catalyst of index inclusion.
Well, in each case, they have a bit of growing to do.
Farmland Partners has been buying back a substantial number of shares for the past couple years, but its price is now at a point where it can issue without destroying value. After having bought back shares in the $6s, $7s, $8s and $9s, reissuing those shares around $12-$14 is a nice full cycle accretion.
FPI seems to be finding accretive acquisitions to put the fresh capital to work such as the recent $26.8 million Louisiana farmland purchase.
At $373 million market cap today, FPI has a way to go to hit the $550 million threshold, but a combination of acquisitions, equity issuance and price appreciation could get it there within a year or two.
BRT Apartments has a particularly clear path to growing its equity base. With over $1 billion in JV assets, BRT could simply use equity to buy out some of its JV partners. They just did this with Bells Bluff and have a wide range of similar JVs on which they could do the same.
At $431 million market cap, WSR is already fairly close to the threshold and could get there rather quickly with its substantial pipeline of acquisitions. They usually acquire about $100 million per year and are on track to beat that pace in 2021.
All 3 of these companies is already involved in well over $1B in assets, so it could just be a matter of recapitalization (more equity less debt) to get them over the threshold.
I am not suggesting that these companies should issue just to get included, but rather that all 3 are on the path of getting there through their normal business operations. Issuance could get them over the threshold tomorrow if that was truly their goal, but more prudent strategic growth will still get them there over the next year or 2.
Again, I don’t think VNQ inclusion is a sufficient reason to invest but it is a great bonus to an already strong investment.
In order anticipate how much inclusion would impact the stock, we must consider the mechanics of the buying.
Upon inclusion, Vanguard will buy somewhere between 8% and 15% of outstanding shares and this is done over a fairly short period of time. Since VNQ is buying regardless of price they end up getting the shares at whatever price clears the market.
Thus, the magnitude of price rise will be related to how much the price needs to rise to create enough sellers to satisfy the demand. Some shares will be available at roughly the current market price, some more at a slightly higher price and so on until about 8% to 15% of current holders feel the price is high enough to want to sell.
In other words, the less price elastic the current holders are, the more the stock will pop. I cannot know what price current holders are looking for, so one cannot know how much or whether a stock will jump up upon inclusion. Historically I have seen pops ranging from 2% to 10% around the time of being added to the VNQ.
I view these as fundamentally strong stocks and undervalued at current pricing. Index inclusion if/when it happens is a nice bonus catalyst to help the stock price get up to fundamental value.
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Disclosure: I/we have a beneficial long position in the shares of FPI, BRT, WSR, PLYM, BNL either through stock ownership, options, or other derivatives. 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.
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