STORE Capital, VNQ, And Buffettism

Apr. 22, 2022 2:23 PM ETSTORE Capital Corporation (STOR), VNQ38 Comments

Summary

  • STORE Capital is Buffett's only REIT holding in his Berkshire Hathaway portfolio.
  • It is also a textbook example illustrating the cornerstones of Buffettism, especially when contrasted with a sector REIT fund like Vanguard Real Estate ETF (VNQ).
  • Do not overstress diversification and do not mistake diversification with diworsification.
  • Do not be stock pickers, be business pickers and pick businesses with a durable moat.
  • And always be conscious of valuation and anchor valuation under the context of risk-free rates.
  • Looking for more investing ideas like this one? Get them exclusively at Envision Early Retirement. Learn More »

Berkshire Hathaway real estate sign in Vail, Colorado

ablokhin/iStock Editorial via Getty Images

Thesis

Investors often face the choice between a sector fund and a specific stock in the sector. This article uses the Vanguard Real Estate ETF (NYSEARCA:VNQ) and STORE Capital (NYSE:STOR) to illustrate the top-down investment approach we use ourselves and also in our marketplace service. This comparison also serves as a classical example to illustrate the cornerstones of Buffettism, given that STOR is Buffett’s only REIT holding and he openly advised against owing index funds such as VNQ if you know what you are doing.

In particular, in this article, you will see that:

  • VNQ is diworsification and why we think a more concentrated bet on STOR actually can LOWER your risks.
  • The business moat of STOR is more durable and stronger than the average of the REIT sector.
  • Finally, despite its strong fundamentals, STOR also features a much more attractive valuation. Especially when evaluated under the context of the risk-free rates, VNQ’s yield spread is near the lowest level in a decade, signaling the worst time to buy in a decade.

VNQ and STOR: basic information

We assume most readers are familiar with VNQ already. It is one of the most popular and largest REIT ETF funds. It holds about 180 REITs stocks in the U.S. and charges a low expense ratio of 0.12%. As a REIT fund, it offers a current dividend yield of around 2.7%, almost more than 2x yield compared to the overall market. Although the yield needs to be properly interpreted under the context of Treasury rates, as to be elaborated on in a later section.

As for STOR, it is one of the largest and fastest-growing net-lease REITs in the U.S. It owns a large, well-diversified portfolio that consists of investments in more than 2,500 properties across the U.S. Buffett holds a sizable position of it, a bit over $0.8B as of this writing. It is not the biggest item in his humongous portfolio, but it is about 10% of total outstanding STOR shares - a strong endorsement of STOR in my view.

Holding/activity history for STORE capital

Source: DataROMA

Do not mistake diversification with diworsification

This first cornerstone of Buffettism is concentration. Do not overstress the importance of diversification, and do not diversify for the sake of diversification.

As you can see from the next two charts, compared to STOR, the REIT sector (represented by VNQ) is really a diworsification. Note that the first chart is based on data provided either from Yahoo Finance or Seeking Alpha around 10AM on April 22, 2022. Given the large volatilities these days, these numbers might have changed a bit when you read this article. A few highlights from this comparison:

  • STOR provides superior profitability, consistency, and also valuation over VNQ. Its price to cash flow ratio is at a 30% discount to the sector average. And do not be alarmed by STOR’s higher price to sales ratio. If you consider that its operating profit margin is almost twice that of the sector average, STOR’s price to sales ratio is actually lower.
  • Particularly, if we use dividends as an approximation for owners’ earning yield, STOR currently provides a yield about 2.4% above VNQ (5.1% vs 2.7% and more on this later).
  • Although note that STOR did suffer higher price volatility than the sector fund. As you can see from the second chart, compared to VNQ, STOR suffered substantially higher volatility (about 2x) in terms of standard deviation, worst year performance, and also maximum drawdown. This is where the second cornerstone of Buffettism becomes crucial. Do not be stock pickers, be business pickers. If you do not feel comfortable with the business fundamentals or are concerned with day-to-day price fluctuations, stay within your circle of competence and do not buy the stock.

STOR vs VNQ

Author

Portfolio returns

Source: www.portfoliovisualizer.com

Pick businesses with durable moat

Thanks to its scale and strong business model, STOR enjoys a moat that is stronger than the average of the REIT sector. As seen in the next chart, the quality of STOR’s business is among the top in its industry by many measures. Among the seven key business metrics for the net lease industry, STOR’s numbers are either the highest or in the first quarter of the industry. Particularly, it enjoys the highest beginning lease yield and the spread between lease yield and borrowing cost among its peers. Its contractual lease escalation, spread between investment AFFO multiple and treated AFFO multiple, and also its ability to accretively recycle asset sales proceeds are among the highest quartile in the industry.

Because of such superior fundamentals, as seen from the chart above, STOR investors have been handsomely rewarded in the past through a combination of earnings growth, valuation expansion, and dividends. The stock delivered 189% of total return since its IPO and outpacing the VNQ sector by a good margin (about 177% of total return).

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Source: STOR Investor Presentation

Always be value-oriented

No matter how good the business is, buying it at the wrong valuation can lead to losses. In particular, Buffett has emphasized himself many times that interest rates act as the gravity on all asset valuation, and valuation always needs to be interpreted under the context of interest rates.

For bond-like equities like STOR, an effective way to evaluate their valuation with interest rates adjusted is to calculate the yield spread. Details of the calculation of the yield spread have been provided in our earlier article on LOW (another stable dividend stock). The yield spread is an indicator we check first, and we’ve fortunately had very good success with this indicator because of:

  • The common PE or Price/cash flow multiples provide partial and even misleading information due to the differences between accounting earnings and owners’ earnings.
  • Dividends provide a backdoor to quickly estimate the owners’ earnings. Dividends are the most reliable financial information and least open to interpretation. In investing, we always prefer a simpler method that relies on fewer and unambiguous data points rather than a more complicated method that depends on more ambiguous data points.
  • The dividend yield spread (“YS”) is based on a timeless intuition. No matter how times change, the spread ALWAYS provides a measurement of the risk premium investors are paying relative to risk-free rates. A large spread provides a higher margin of safety and vice versa.

With this background, you will see below that when adjusted for interest rates, the current valuation of STOR is even more attractive than on the surface.

The first chart below shows the yield spread between STOR and the 10-year treasury. The yield spread is defined as the TTM dividend yield of STOR minus the 10-year Treasury bond rate. As can be seen, the spread is bounded and tractable. The spread has been in the range between about 1.25% and 3.0% the majority of the time, which makes sense for a stable and mature business like STOR. Suggesting that when the spread is near or above 3%, STOR is significantly undervalued relative to 10-year treasury bond (i.e., I would sell treasury bond and buy STOR). In this case, sellers of STOR are willing to sell it (again essentially an equity bond) to me at a yield that is 3% above a risk-free bond. So it is a good bargain for me. And you can clearly see the screaming buy signal during the 2017 and 2020 pandemic panic sales when the yield spread hiked to be near or above 3% - precisely the times that Buffett bought.

And as of this writing, the yield spread is about 2.2%. Despite the recent surges in treasury rates, it is still near the thicker end of the historical spectrum. Our view is that treasury yields are close to their long-term targets already. But in any case (i.e., in case we are wrong), such a yield spread signals very manageable valuation risks ahead for STOR and also provides a comfortable cushion against further interest raises.

STOR yield against 10 treasury

Author

In contrast, the picture for VNQ is completely different and much more concerning. As you can see, as the 10-year treasury rose toward 3%, it pushed the yield spread between VNQ and risk-free rates to the thinnest level in a decade. Again, the spread is bounded and tractable most of the time as expected. The spread has been in the range between about ~0% and 2.75% the majority of the time during the past decade. And as of this writing, the spread is about NEGATIVE 0.2% as you can see. It is the thinnest level in a decade.

As a matter of factor, according to our Market Sector Dashboard (you are welcome to download it using this link too), the REIT sector is currently among the most overvalued sectors.

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Author

Risks

There are a few risks associated with STOR though.

First, STOR (like any other typical REIT business) relies on debt financing and is therefore somewhat sensitive to interest rate change.

Second, the ongoing pandemic is also a risk. STOR has tenants who are directly exposed to the pandemic, such as restaurants, theaters, and health clubs.

Third, Volk’s recent departure. STOR’s founder and executive chairman, Chris Volk, has recently announced that he will resign as chairman of the board and as a board member or manager of any company affiliates. Volk has been a successful series entrepreneur, and he must be a key consideration in Buffett’s investment decision. His departure creates uncertainties in the leadership and management of STOR.

Conclusions and final thoughts

A comparison between STOR and VNQ illustrates the key cornerstones of Buffettism. In particular,

  • Do not overstress diversification and the VNQ represents a diworsification compared to STOR. STOR provides superior profitability, consistency, and also valuation over the REIT represented by VNQ.
  • Do not be stock pickers, be business pickers. If you stay within your circle of competence and understand the fundamentals of the stocks you are picking, fewer holdings not only lead to better returns but also LOWER your risks.
  • Finally, always be value-oriented and anchor valuation under the context of risk-free rates. Our Market Sector Dashboard shows the overall REIT sector is currently among the most overvalued sectors. The spread between VNQ and the 10-year treasury yield is NEGATIVE 0.2% currently, the thinnest level in a decade. While the yield spread between STOR and treasury yield is about 2.2%, near the mid of its historical spectrum, signaling very manageable valuation risks ahead and also providing a comfortable cushion against further interest raises.

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** Disclosure: I am associated with Sensor Unlimited.

** Master of Science, 2004, Stanford University, Stanford, CA 

Department of Management Science and Engineering, with concentration in quantitative investment 

** PhD,  2006, Stanford University, Stanford, CA 

Department of Mechanical Engineering, with concentration in  advanced and renewable energy solutions

** 15 years of investment management experiences 

Since 2006, have been actively analyzing stocks and the overall market, managing various portfolios and accounts and providing investment counseling to many relatives and friends.

** Diverse background and holistic approach 

Combined with Sensor Unlimited, we provide more than 3 decades of hands-on experience in high-tech R&D and consulting, housing market, credit market, and actual portfolio management. We monitor several asset classes for tactical opportunities. Examples include less-covered stocks ideas (such as our past holdings like CRUS and FL), the credit and REIT market, short-term and long-term bond trade opportunities, and gold-silver trade opportunities. 

I also take a holistic view and watch out on aspects (both dangers and opportunities) often neglected – such as tax considerations (always a large chunk of return), fitness with the rest of holdings (no holding is good or bad until it is examined under the context of what we already hold), and allocation across asset classes.

Above all, like many SA readers and writers, I am a curious investor – I look forward to constantly learn, re-learn, and de-learn with this wonderful community.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.

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