- Right now, everything seems to be dropping.
- The S&P 500, tech stocks, REITs, etc.; everything is on sale.
- Here's what I am buying.
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Right now, the entire stock market is facing significant selling pressure due to one main reason: interest rates.
Since the beginning of the year, the 10-year Treasury has nearly doubled and is now nearing 3%.
At the same time, the Fed said that it will need to hike interest rates significantly in the near term. According to Jerome Powell, a 50-basis point hike is on the table for May, and some are even predicting a 75-basis point hike, something that would have been unthinkable just a few months ago.
Deutsche Bank's chief economist believes that the Fed could hike interest rates to above 5% by the time it's done, a level not seen since 2006.
What this means for stocks
It of course depends on what you look at, but generally speaking, these potential hikes are quite negative and that's why the market has become so volatile.
Higher inflation and interest rates lead to lower profitability, and importantly, they also lead to lower valuation multiples.
You simply cannot justify the same earnings multiples when interest rates are higher, and this is why tech stocks have performed so poorly in recent months.
The S&P 500 (SPY) is down 13%, Tech stocks (QQQ) are down closer to 20%, and the fastest-growing, highly innovative tech stocks such as those owned by ARK Invest (ARKK) are down over 50%. That's just in a few months!
Is this a buying opportunity?
I believe that it is, but not for all stocks.
The title clearly suggests that I am buying the dips, and that's what I am doing in specific sectors of the market.
These sectors are REITs, asset managers, and tech stocks.
Below I explain why.
REITs (VNQ) are today feared by the market due to the rising interest rates. Most of them are still barely catching up to pre-covid levels, and quite a few are still yet to recover and trade at steep discounts.
That's rather spectacular given how much real estate has appreciated since the beginning of the pandemic. We are in one of the hottest real estate markets of all time and yet, a lot of REITs are still priced as if real estate values had remained flat over the past two years.
This just goes to show you how pessimistic the market has become. The common narrative is that REITs underperform during times of rising interest rates because it leads to higher mortgage rates and also higher cap rates, which is the equivalent of lower earnings multiples.
But this narrative is far too simplistic because it fails to consider other important factors.
Today, interest rates are rising because inflation is at a 40-year high, and I am sure you have heard before that inflation is good for real estate investors.
It leads to higher rents, grows the replacement cost of your property, and also lowers the new supply of competing projects as construction and labor costs go up. That's well-known to most people.
However, what a lot of people forget is that inflation also benefits property owners by lowering the real value of their mortgages.
Let's look at an example:
We assume that you buy an apartment community and finance half of it with a 4% fixed-rate mortgage with a 10-year term.
Now, you are suddenly able to hike rents by 15%, but your interest expense does not change because you have a fixed rate, and your debt loses 8% in real value each year since it isn't protected against inflation.
Naturally, that's going to have a very positive impact on your equity value. The value of your property goes up, but the value of your debt goes down.
This explains why real estate investments have performed so well, but a lot of REITs have failed to reprice at higher levels due to fears of rising rates.
The public REIT market simply appears to ignore that the positive impact of inflation is superior to the negative impact of rising rates.
By the way, this is not just my opinion. If you look at historical data, you will find that REITs have performed very well in the past during most periods of rising rates. On average, they have delivered a 17% return in the 12 months following rate hikes, which is nearly two times better than the S&P 500:
This shows you that buying REITs after they sell-off due to concerns of rising interest rates was generally rewarded with rich gains during previous historical periods. We expect similar performance this time around, and that is why we are accumulating undervalued REITs.
If you want further evidence that REITs are undervalued, just look at all the recent buyouts from private equity players. REITs have become acquisition targets because they provide exposure to real estate at a discounted price. Some of the latest acquisitions include American Campus Communities (ACC), QTS Realty (QTS), and CyrusOne (CONE), and we expect a lot more of them in the coming quarters because, in a world of high inflation, it is very compelling to buy real estate at a discounted price.
Alternative Asset Managers
Alternative asset managers are those that focus mainly on private equity, infrastructure, commercial real estate, and other alternative investments.
Some of the biggest and most successful include Blackstone (BX), Brookfield (BAM), KKR (KKR), and Carlyle (CG). They make money by managing alternative investments for others and earnings fees in exchange.
It is a business that can be very rewarding if you are able to grow your assets under management and with interest rates at very low levels, there has been a lot of demand for alternative investments.
But with interest rates now back on the rise, the market fears that alternative asset managers will have a harder time growing, and it has caused their share prices to drop significantly:
We think that this is a great opportunity.
Sure, if interest rates were the only factor, the recent surge would negatively impact asset managers.
But just like with REITs, there are other important factors to take into account, and some of these factors strongly favor alternative investments.
We have already discussed how inflation benefits a lot of alternative assets, but it is important to also remember how it hurts fixed-income investments. Even with interest rates at materially higher levels, the real interest rates (after inflation) remain negative, and therefore, we wouldn't expect bonds and treasuries to steal the lunch of alternative asset managers.
Moreover, it is today more important than ever to be well-diversified because we live in a highly uncertain world with a raging pandemic and a dangerous war in Europe, which are causing significant volatility.
Therefore, we think that major investors will only keep on adding more capital to alternative investments, even despite the surge in interest rates, and now is a good time to accumulate shares of these asset managers while they are discounted.
One of my favorites, KKR, is down 50%+ over the past year, and I think that it was reasonably priced even at its peak.
Finally, I couldn't resist it and bought some tech stocks in the weeks and will continue to accumulate.
Tech stocks are the most negatively impacted by rising interest rates and probably my riskiest purchases, but they are also potentially some of the most rewarding.
They are the riskiest because even after the dip, their valuations still aren't "cheap" if inflation remains high and interest rates rise materially higher.
However, if we get inflation under the control sooner rather than later, then I would expect tech stocks to rapidly recover closer to where they traded in 2021.
The reality is that a lot of these tech stocks have great fundamentals, they are growing fast, and have bright prospects, but they sold off heavily because their valuations are extremely sensitive to interest rates.
In a 0% rate world, you can justify almost any valuation, but with rates even at just 3%, the math works very differently.
Believe it or not, I still think that the recent surge in inflation is transitory and that we will remain in a "lower for longer" environment, and therefore, now is a good time to accumulate tech stocks as well.
Historically, it has always paid off to buy the dips when the market became fearful. I don't think that this time will be any different and I expect my targeted purchases to enjoy a lot more upside than your average stock in the coming years as share prices recover.
Right now, most of my capital is going into the REITs and asset managers that we discuss at High Yield Landlord, and I am using a smaller portion of my capital to accumulate tech stocks for extra diversification.
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This article was written by
Jussi Askola is the President of Leonberg Capital, a value-oriented investment boutique that consults hedge funds, family offices, and private equity firms on REIT investing. He has authored award-winning academic papers on REIT investing, has passed all three CFA exams, and has built relationships with many top REIT executives.He is the leader of the investing group High Yield Landlord, where he shares his real-money REIT portfolio and transactions in real-time. Features of the group include: three portfolios (core, retirement, international), buy/sell alerts, and a chat room with direct access to Jussi and his team of analysts to ask questions. Learn more.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of KKR, PAR, WPLCF, TDOC 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.