BIKES, PHYSICS, TAXES: MARCH 2021 NEWSLETTER
Updated: Sep 8, 2022
PERFORMANCE: – Serenity Alternatives Fund I returned +5.8% in March net of fees and expenses versus the FTSE NAREIT REIT index at +5.5%. Year to date the fund has returned +13.4% versus the REIT index at +8.4%.
RETURN OF THE TOWERS: Infrastructure REITs led all sectors in March up +10.5%.
RIDE THE CYCLE: Macro-economic data is improving at a rapid rate as the economy re-opens.
FUEL FOR THE FIRE? Why a reversal in tax policy under the current administration should be beneficial for REITs.
“Life is like riding a bicycle. To keep your balance, you must keep moving.”
– Albert Einstein
For better or worse the capital markets never stop moving. They are constantly evolving, assimilating data, adjusting their prices, speeding up, and then slowing down. To navigate them successfully requires balance, and the ability to continually change your views as the data changes. If your portfolio stays static for too long, chances are it will tip over and fall down.
Even following a string of successes, mental flexibility is of paramount importance. Climbing a hill to the summit is rewarding, but you still have to get down the other side. And balance can be even more important when going downhill. Lose your balance, and you may find yourself flying over the handlebars.
As the economy reopens and economic data points surge higher, Serenity continues to ride the wave of positive news that has driven our portfolio over the last six months. That does not mean, however that we do not have one hand on the breaks, ready to slow down and pivot when necessary. Our viewpoint continues to evolve with the data, consistently moving forward in order to tweak and refine our portfolio for maximum balance.
In March our fund was able to navigate a different environment than that of January and February, while still delivering benchmark beating returns. Exposures to more expensive growth REITs benefited the fund in March, while our more value-focused ideas took a breath after an incredible 6-month run.
Going forward, we are poised to navigate whatever path the economy takes, and current data points continue to point in one direction… up and to the right.
PERFORMANCE: +5.8% IN MARCH, +13.4% YTD Serenity Alternatives Fund I returned +5.8% in March net of fees and expenses versus the FTSE NAREIT REIT index at +5.52%. The fund has now returned +13.4% for the year, versus the REIT benchmark at +8.4%, a difference of +4.99% net of fees in 3 months. Over the last 15 months, the fund has returned +35.5% net of fees while the REIT benchmark is up only +2.8%. Since 2019, the fund has generated annualized returns of +30.1%, with a Sharpe ratio of +1.92, while having a net exposure of +70% on average. The best performing position in the fund this month was Extended Stay America (STAY). STAY returned +22.8% in March and was written up as one of our best ideas in last month’s newsletter. Evidently, the folks at Blackstone and Starwood capital agreed with our positive outlook, as these two titans of the commercial real estate industry came together to purchase STAY at $19.50, a deal that was announced on March 15th. As we discussed in our February newsletter, STAY is positioned to benefit disproportionately amongst its peers in the lodging space as the economy re-opens. The portfolio had already reached 2019 occupancy levels in August of 2020 and continued re-opening would only serve to drive further occupancy and RevPAR gains. For these reasons we are inclined to agree with STAY shareholders who have argued that the deal under-values the company. While the outcome is favorable for our clients either way (our basis in the name is $12.50), we would prefer the company remain public, continue to drive RevPAR higher, close the multiple gap with peers, and achieve a more favorable outcome for shareholders via a much higher stock price. Simply applying a 13.5x multiple to 2019 EBITDA (which is achievable for STAY by 2022) would value the company at $22.80, a 17% premium to the announced deal price. The worst performing position in the portfolio this month was Mack-Cali Realty Corp (CLI), which was a short position in the fund and returned +10.65%. CLI has been a serially under-performing New Jersey focused Office REIT which is currently selling its office portfolio as it transitions to a company focused in apartments. CLI has negative NAV growth, a low-quality portfolio, and elevated leverage; all the hallmarks of a REIT our model is built to short. CLI is an interesting and important case study in style investing, however, as the company was clearly a poor performing short idea during the month of March. CLI is what most REIT investors would consider a “low quality company.” The CLI portfolio, management team, and track record all rank near the bottom of the REIT market, and yet they were one of the best performing REITs last month. So what gives? This is an example of when a style investing lens can be insightful. The fact of the matter is that sometimes (in fact a good portion of the time), low quality companies out-perform high quality companies. Rapid cyclical economic expansions (as we are currently experiencing) tend to be an environment in which these “junk” type companies do particularly well. Now does this mean we should abandon the model’s quality factors and purely buy junky companies? Probably not, as these companies are extremely volatile and tend to under-perform over the full cycle. That being said, having the wherewithal to know the dangers in shorting low-quality companies amidst significant economic momentum can save savvy investors serious $$. We unfortunately failed to identify CLI as a dangerous short in March. We have learned our lesson and will be more vigilant with the short book going forward.
RETURN OF THE TOWERS: WHY BALANCE IN A PORTFOLIO MATTERS
Growth investors rejoiced in March as the core growth complex within REITs came charging back after a lack-luster start to the year. Infrastructure (Cell Towers), Single Family Rental, and Warehouse REITs were three of the top performing property types in March and remain three of the fastest growing sub-sectors in the REIT universe. Year to date, these sectors still rank near the bottom of the REIT market in terms of performance, with value sectors Malls, Shopping Centers, and Lodging leading the pack so far in 2021. In recent newsletters we have emphasized the importance of including value REITs in a portfolio, especially in this type of macro-environment. To re-iterate our position, we believe that early in economic cycles, value stocks (and by extension value REITs) tend to out-perform their higher growth cousins by a significant margin. This positioning has led the fund higher by +32% over the last six months, versus the REIT index at +17%. The fund leaned into value late in 2020, when many REIT investors would not touch it with a ten-foot pole.
The operative word in the previous paragraph, however, is leaned. While it would have been nice to jump into value with two feet in October of 2020, that type of all-in approach is extremely dangerous over the long run and would have led to terrible performance in a month like March. By maintaining balance in the portfolio (maintaining some growth exposures while leaning into value), the fund was able to outperform the REIT index in March in spite of many of our major positions delivering below-average returns. Balance is key to generating strong risk-adjusted returns that are scalable and repeatable, which is our goal. A balanced approach keeps you in the game while your best players are temporarily on the bench. From a historical perspective, the importance of balance in a REIT portfolio is evident. When studying the best performing REITs over the period from 2010-2020, the vast majority are growth-type REITs, which is why in fact our model is designed with growth and momentum components.
So what does this mean for current positioning? While we continue to favor opportunities in out of favor value names, our portfolio does maintain exposure to faster growing, more expensive growth REITs as well. As the cycle matures and growth eventually becomes scarcer (right now the opposite is happening), our emphasis on growth will increase. For the time being, however, we will own growth selectively, allocating to names that fit our macro-economic, style, and fundamental outlook.
RIDE THE CYCLE: MACRO-DATA IS ACCELERATING
Speaking of our macro-outlook, March was a profoundly important month in terms of macro-economic data. Up to this point, economic strength was mostly a rumor, or a hope based on increasing vaccination rates and increasingly favorable sentiment. The month of March, however, marked the first month with concrete evidence that the economy is accelerating meaningfully, and that economic strength is broad based. The chart below displays the ISM manufacturing index, one of the most predictive measures of GDP in the macro-data universe. While the ISM index has been recovering over the past year or so, it broke significantly higher in March, breaking above 64, the highest reading since 1983. The ISM employment index (a sub-component of the manufacturing index), accelerated as well, breaking 60 for the first time since 2018.
In addition to the manufacturing index, the ISM services index also broke meaningfully higher in March, posting a reading of 63.7, the highest value in the history of the series. Services are arguably the most important aspect of the economy at this juncture due to the fact that many were completely shut down for the better part of 2020. With vaccinations moving along at a rapid clip, CEO’s and consumers are clearly starting to increase their activity as we move towards a post COVID world.
The final positive indicator worth noting for the month is arguably the most important, jobs. Hiring people is the ultimate vote of confidence, and a true sign that businesses and the economy generally are beginning to heal. Positive and accelerating job creation over the past 3 months has a self-reinforcing effect that should continue to drive economic growth higher. More jobs mean more apartment rentals, more office space absorption, more retail spending, and an overall healthier environment for REIT tenants.
These data series are extremely important because they confirm our thesis that the economy is entering a new growth cycle that should drive REIT cash flows higher over the next 3-5 years. While the stabilized level of demand for office space, retail spending, or lodging assets is un-knowable, the tailwind of higher employment and therefore higher income levels is very much moving in a favorable direction for these companies.
TAXES: LEVELING THE PLAYING FIELD?
While increased cash flow will be the primary driver of REIT returns over the next few years, other catalysts exist that may benefit the sector moving forward. One that may be flying under investor radars is the potential for higher corporate tax rates. While higher potential taxes are not a surprise, the investment implications are not always evident. For REIT investors that remember late 2017 and early 2018, the implications are clear and profound. The chart below displays performance of the S&P 500 and the REIT index beginning about three months prior to the corporate tax cuts passed by the previous administration. These cuts were signed in late December of 2017 and went into effect in January of 2018. What is clear is that REITs diverged from the broader market in anticipation and then realization of this significant change in the tax landscape to the tune of -14.9%.
The rationale here is that REITs pay $0 in corporate taxes. In exchange for this favorable tax treatment, they have to pay out 90% of their taxable income in the form of dividends. Because of this favorable tax treatment, all things equal, lower corporate taxes are BAD for REITs because their tax advantage relative to traditional c-corps narrows. It would hold then, that the opposite scenario would be positive for REITs. With the federal deficit hitting all time highs and a potential multi-trillion-dollar infrastructure bill in the works, it should come as no surprise that the current administration is contemplating higher corporate tax rates. While the puts and takes of higher taxes can be debated ad nauseum, the impact for REITs is straightforward. Higher corporate taxes make REITs a more attractive relative investment to stocks on the margin. While a more favorable tax treatment may not be the most exciting catalyst for REITs, improving cash flows, combined with the potential for renewed investor interest in the sector bodes well for the space going forward.
STAYING THE COURSE
As the economy emerges from recession and the global pandemic begins to recede, REIT cash flows will continue to move higher along with broader macro-economic data. March delivered compelling evidence of economic acceleration, and the Serenity portfolio remains positioned to take advantage of further economic strength. With a nuanced outlook and a balanced portfolio, our process continues to reap the benefits of its flexible yet concentrated nature. We continue to ride forward with two hands firmly on the handlebars. Pedal to the medal,
Martin D Kollmorgen, CFA CEO and Chief Investment Officer Serenity Alternative Investments Office: (630) 730-5745 MdKollmorgen@SerenityAlts.com
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