Risks, Real Estate and Reality

After a two week hiatus, I am back with my regular weekly ramblings and ruminations on markets and anything else that strikes my fancy. One week was missed due to Thanksgiving of course but the week prior my wife ha dot fly off to Texas due to a family emergency leaving me with homefront duties. It has been years since I had to do all that unaided and between feeding a 13 year old, the cats, the dogs, off to school , home from school, homework patrol and musical theatre practice schedules (the youngest has traded her plans for pop star divadom with a sparkling flashy clothing line for a career amongst the footlights of Broadway and an EMO clothing line) this is one of the weekly articles that got whacked.

While I was gone, I did a lot of reading and catching up with the third quarter commentary coming from some of the leading mutual and hedge fund managers. One of my greatest strengths has been that I know I am not the smartest guy in the room and being able to figure out who that person was. I have become superb at listening to the smart guys and then filtering it all through my own gray matter to develop a high conviction opinion about the world. I want to share some of the insights garnered over the last couple of weeks that might help us steer through the murky waters ahead.

Daniel Loeb of Third Point pointed out some major macro concerns including global fiscal and monetary policy, low growth expectations, and China as factors to consider when looking at the markets. He also expressed concerns about the economy going forward telling his shareholders that “We are clearly in the late stages of a business cycle following an eight-year (tepid) expansion. While we do not forecast a financial crisis or a recession, a clear path to growth seems elusive. Consumers have been reducing spending and businesses have never regained their pre-2008 capital investment levels. We might soon long for 2% GDP growth.”

He also noted how the investment game has changed over the year with macro playing an ever larger role in the process. He wrote that” This last observation dovetails with both the opportunity and the challenge we face investing today. We have seen a return to a “stock-pickers” market this year. However, that term does not mean what it did fifteen or twenty years ago when we were in our infancy. Then, picking stocks could be done in a virtual bubble and all of our time was spent deep in financial statements. While our analyst team still spends the vast majority of its workday analyzing fundamentals, getting overall portfolio positioning right is equally essential to generating returns. The macro considerations discussed above must be interpreted correctly and applied successfully. When we add in the use of data sets and “quantamental” techniques that are increasingly important to remain competitive while investing in single-name equities, it is clear that our business is rapidly evolving.”

CBRE Clarion Securities manages several real estate related funds, and they are positive about global real estate investing right now. In their latest commentary, they noted that “Listed property companies at September 30th traded at an estimated 5% discount versus the private market estimated net asset value (NAV). The implied global weighted average cap rate of 5.6% compares favorably to fixed income alternatives and a cost of capital which remains historically low. In the U.S., the modest premium is driven by pricier net lease, health care and date center property types while the “core” real estate sectors of apartments, retail, office, industrial, and lodging remain at a discount to our estimate of private market value. The U.K. “majors”, with significant portfolios concentrated in London, continue to trade at discounts exceeding 15% post-Brexit. Implied cap rates for many of the U.K. majors are in the 5% range. Many Asian developers trade at over a 35% discount to NAV, materially below their long-term averages with implied cap rates in many cases exceeding 6%. A key observation and insight globally is that cap rates have remained low given negative policy rates, low bond yields, low levels of inflation and wide spreads between cap rates and the cost of capital. A significant amount of “dry powder” from investors in the private markets, including private equity, pension funds, and sovereign wealth, too, is underpinning cap rates. Over $200 billion of estimated “dry powder” remains available in the U.S. alone for prospective investment in commercial property, before taking into account any leverage.

Michael Winer at Third Avenue Real Estate is also upbeat about the long-term prospects, particularly the US housing market. He writes to his shareholders that “In all cases, the fundamentals for these businesses continue to improve from the Great Depression-like levels that they endured during the U.S. housing crisis of 2007-2009. To fully appreciate how much conditions have changed, it is worth noting some of the fundamental improvements over the past five years (2011-2016). During that time period, there have been 13.7 million additional jobs added in the U.S., leading to the unemployment rate falling from9.5% to below 5.0%and millions of new home buyers entering back into the market. In fact, existing home sales have returned to more normalized levels, recently surpassing 5.5 million annually, with the additional purchasing activity serving to reduce the amount of excess inventory (once above 11 months) down to historically low levels (currently below 5 months), leading to a recovery in residential prices and demand for new building. As a result, home improvement spending has increased by more than $30 billion over the past five years to approximately $150 billion annually, and new construction activity has more than doubled with new home starts now at 1.2 million annually versus500,000 just five years ago.”

I share their long-term enthusiasm.We own a lot of REITs and real estate related companies, including broad exposure to the single family home marketplace. Also, a healthy real estate market is fantastic for our community bank stocks as real estate is the bulk of the collateral propping up their loan portfolios.

When it comes to the broader market, there is a lot more concern from some very smart people. I have known the guys at Tweedy Browne for a long time and consider them to be some of the very smartest people in our business. IN their most recent shareholder letter the Managing Directors noted that “We briefly want to address some of the other nagging topics in the world of investing, as they are part of the investment landscape for many, and some factor into why we find ourselves where we are currently. As a general observation, here at Tweedy, Browne, we think – and maybe even know – that after a 7-plus year rise in financial markets, the world holds few bargains, which should not come as a surprise to anybody. Moreover, given the enormous amount of liquidity looking for investment homes, it is not surprising that the prices of many securities have very little room for disappointment built into them.”

The FAQ section of the report they included a question that is being asked on a regular basis these days that addressed one of the cherished beliefs of today’s stock market bulls. The question of the day is “Has the decline in interest rates over the last many years led us to increase the multiples we use to calculate intrinsic values on the businesses in which we invest?” Their reply is long, but a must read for the average investor.

The answered that “The answer is for the most part “no.” If we were certain that interest rates would remain permanently low, then our answer would likely be different; however, we are not subscribers to the notion that zero to negative interest rates are here to stay. We tend to believe that interest rates are being artificially depressed by central banks and will likely increase to a higher more normalized level over time. We also take a rather conservative approach to business appraisal. In calculating intrinsic values for the businesses we consider for investment, we are informed by the prices being paid in real life acquisitions of comparable companies by acquirers – often expressed regarding a “multiple.” We calculate this multiple by dividing enterprise value (EV) (which is the sum of market value and interest-bearing net debt) by EBIT (earnings before the deduction of interest and taxes); EBITA (earnings before the deduction of interest, taxes, and non-cash intangible amortization); or EBITDA (earnings before the deduction of interest, taxes, depreciation and non-cash intangible amortization). Other multiples we use are price divided by after-tax earnings per share (P/E) and price divided by book value per share (P/B). While studying real life comparable acquisition multiples helps inform our view of a company’s intrinsic value, we do not blindly extrapolate observed deal multiples. Sometimes we believe buyers overpay, particularly when acquisitions can be financed with low-cost debt. To that end, in addition to requiring that a company be inexpensive relative to where comparable companies have been acquired in real life acquisitions, we also require that the company be cheap on an absolute basis. This additional test is more of an absolute approach to valuation using tried and true multiples that are linked to real return math. For example, we would not pay 15X EBITA for a company even if deal comparables indicated that buyers had been willing to pay 23X EBITA for similar businesses. Rather, we tend to value most businesses using an enterprise value multiple of between 10 and 12 times annual pre-tax operating income (EBIT or EBITA) when calculating intrinsic values, which equates to a pre-tax earnings yield of between 10% and approximately 8% on the debt free value of the business. This compares more than favorably to low, riskfree interest rates, and we believe is reasonable compensation for the equity investor. In making a new investment, we generally seek a discount of at least one third (we seek a lesser discount in the Worldwide High Dividend Yield Value Fund) off of this more conservative estimate of intrinsic value, which implies a purchase multiple between 6X and 8X enterprise value to EBIT or EBITA.” That’s a long way away for the current median market EBIT multiple of more than 15.

The managers of the FPA Capital Fund also struck a very cautious note and expressed the merits of cash telling their shareholders that “If our assessment of the situation is correct, the market – as a whole – is expensive. Some try to justify it with P/E ratios, as if the 29.8x P/E multiple for the Russell 2500 is low. For starters, that multiple only includes the companies that have positive earnings. How about the 30% of the Russell 2500 companies that have negative earnings? Perhaps the best way to look at it is to assess where we are historical. The chart below shows that, as of the end of the third quarter, the Russell 2500 was only 2.6% off its recent all-time high. Guess when the enterprise value-to-EBITDA -multiple (EV/EBITDA) hit its peak? On Sept. 30, 2016, the Russell 2500’s EV/EBITDA stood at 19.5x – significantly higher than its 11.9x average over the last decade-plus. It is also interesting to note that EV/EBITDA hit its low of 6.9x in November 2008. Since the market bottomed on March 8, 2009, the Russell 2500 has increased by 277%, the cumulative EBITDA increased by 57%, and the EBITDA multiple increased FPA Capital Fund 3Q16 Commentary; Up 12.28 Percent by 142%. If and when market participants come to the same conclusion (like they did during the dot-com bubble and the great financial crisis), many would try to go through a narrow door all at the same time. During such a time, we would expect a high-level panic, which will create forced selling. An elevated level of forced selling, combined with a lack of liquidity, might result in challenges for many fully invested products such as index funds, many ETFs, and funds that have no to very low levels of cash cushions. Many investors put very little value on cash, arguing that cash’s current low yield makes it a poor investment. However, we believe cash’s value comes not from its current yield, but from its optionality. In a down market, cash helps mitigate losses and affords one the opportunity to buy when others are being forced to sell (generally the best time to buy).”

My return to Thursday is much longer than usual, but there are some very smart people saying things that you need to know about before rushing to throw your money into the markets. There are pockets of opportunity in small banks and some REITs but the market is very elevated, and the risks strike me as high right now.

Posted to The Community Bank Investor… on Dec 01, 2016 — 3:12 PM
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