“Always mind your surroundings.”
– Henri Ducard, Batman Begins
• PERFORMANCE – Serenity Alternatives Fund I returned +7.6% in February net of fees and expenses versus the FTSE NAREIT REIT index at +2.7%.
• RE-OPENING MOMENTUM: Hotels, Malls, and Retail REITs led all REIT property types in February as investor optimism increased and fundamentals stabilized.
• EXTENDED STAY AMERICA (STAY): One of Serenity’s best ideas in the Lodging space reported strong 4Q results and is positioned for continued success.
• RISING INTEREST RATES: Should the recent run-up in the 10-year treasury yield be cause for concern?
There is something endlessly enthralling about Batman and his place in the realm of superheroes. Batman has no super-powers. No super-strength, no X-ray vision, no magical abilities. He had to work to build himself into a crime-fighting powerhouse, something relatively unique within a universe of super-powered beings.
And despite its elements of fantasy, the story of Bruce Wayne’s transformation into Batman is eminently relatable. While few of us will spend years learning martial arts on a frozen lake high in the mountains; the daily struggle of building a company or running a business can be similarly cold and exhausting.
The same goes for developing a lasting investment process. Consistent effort and discipline are key. Despite what the media may suggest, nobody is born with the ability to see around corners. Those of us that choose to invest professionally have to train, practice, and importantly, learn to mind our surroundings.
That last lesson has never been more important than over the last six months. Investors myopically focused on company fundamentals (sales and earnings) have missed a massive shift in sentiment that has completely altered the investing landscape. Those with the ability to observe their changing surroundings and adjust their positioning, however, have thrived. This month we dig into an advanced investing topic that can be powerful when used correctly: Style investing.
PERFORMANCE: +7.6% IN FEBRUARY, +7.2% YTD
Serenity Alternatives Fund I returned +7.6% in February net of fees and expenses versus the FTSE NAREIT REIT index at +2.7%. Since the beginning of 2020, the fund has now returned +27.0% versus -2.56% for the REIT benchmark. A challenging environment for many investors has turned out to be an excellent opportunity to illustrate the power of Serenity’s multi-factor strategy. Since the end of 2018, the fund is up +70% net of fees and expenses, rewarding investors that stuck with our process through early years of development and testing. Since implementing our process in its current form, the funds returns are more than double that of the REIT index.
The two best performing positions in the fund in February were Pebblebrook (PEB) +23.5% and Simon Property Group (SPG) +21.8%. As recently as a few months ago, having significant positions in the Hotel and Mall REITs would have sounded completely crazy. Conventional wisdom held that the lodging industry was on life support, and that malls were certainly on their way to non-existence. Even today negativity is pervasive, as there are few tangible signs of improving fundamentals in these property types.
Fundamentals, however, are only one variable in the stock market equation. Style factors, and macro-economic factors have played a much larger role recently in REIT performance than say, earnings growth. This is what we mean when we say “mind your surroundings”. It’s not only traditional data points that are important.
The performance of CyrusOne (CONE) this month further illustrates this point. CyrusOne reported 4Q earnings in February with sales up +6% YoY and FFO per share up +1%. Conversely, Simon Property Group (SPG) reported sales growth of -24% and FFO per share of -27%. From a fundamental standpoint, CONE reported much more favorable results, and yet returned -9.9% for the month versus SPG at +21.8%.
While CONE is one of our best ideas from a fundamental outlook standpoint, it suffered from a high correlation with tech stocks during the month, as well as a valuation that is elevated relative to many beaten down REITs. These “style factor” exposures were a negative for CONE in February, causing the stock to fall. Our portfolio, however, remains tilted more heavily towards deep value and re-opening factors, which is why the fund was able to easily overcome sub-par returns in Data Centers and Warehouse REITs this month.
RE-OPENING DOMINATION: MALLS ARE DEAD, LONG LIVE THE MALLS
The major theme of REIT investing in February remained the dominance of the “re-opening” trade. Lodging, Malls, and Shopping Center REITs led all property types during the month and have led REIT performance for the past 6 months. This stands in stark contrast to 2020, in which each of these property types fell significantly in the first part of the year, before recovering a portion of their losses in the fourth quarter. The continued success of this strange combination of REITs creates a perfect opportunity to further our discussion of style factors and why they are so important. Style Factor analysis is a large part of our process at Serenity and accounts for a significant portion of our recent outperformance. We spent years building and testing a library of over 85 REIT specific style factors, eventually culling out a combination of 19 that are used in our CORE REIT model. As a part of this process, we are constantly seeking to understand when certain investing styles work within REITs and why. This way, we can insulate our portfolio from large “style” shocks that catch other investors un-aware.
The most recent 6-month period represents just such a “style shock”. While “re-opening” is not a traditional style factor, it has been far and away the most important driver of stock returns ever since Pfizer announced their vaccine results in November. Additionally, the “re-opening” factor actually looks a lot like a much more common factor group…that of Deep Value.
Sound familiar? If you rewind the tape to August/September of last year, nobody in their right mind was pounding the table for Deep Value as a strategy except for us. There was good reason for this. Contemplating over-weights in the Hotels, Malls or Shopping Center REITs sounded crazy. Viewed through the lens of property types and fundamentals (how most REIT investors view the world), there was no rational justification for owning any of these REITs.
From a style factor perspective, however, there was.
As we wrote in our September 2020 newsletter, “Some economic environments are much better for deep value investing than others…The bottom of economic recessions tend to be these sorts of times.” Dusting off a deep-value framework just before a late year surge in Coronavirus cases seemed insane, but it was, in-fact, nearly perfectly timed. We knew that the worst economic damage had been done in April and May, and that this particular style (Deep Value) tended to exhibit some of its best performance in post-recession periods. This led us to the non-consensus position of long Hotel, Mall, and Office REITs.
The results over the last six months speak for themselves. Using our Deep Value model as a proxy for “re-opening,” Serenity has been able to successfully navigate a huge change in sector-level REIT performance. As we continue through the early stages of this new economic cycle, our fund will continue to focus on these drivers of investing returns that are rarely discussed, difficult to observe, and therefore brimming with opportunity.
EXTENDED STAY AMERICA (STAY): WHEN STYLE MEETS STORY
Having a process dependent on style factors working together with fundamental analysis can be challenging, but also exciting when different aspects of the process point in the same direction.
Extended Stay America (STAY) is a good example of style and story converging on an individual company, making it one of our largest portfolio holdings and best ideas. STAY is a top-ranked name in both our CORE REIT (Value/Momentum/Quality) model and our Deep Value model. The company also has a favorable fundamental outlook and should benefit from the continued re-opening progress in the economy.
From a momentum perspective, STAY ranks #3 in 12-2 momentum, #22 in short-term momentum, and #33 in intermediate NAV momentum within our 139-company universe. From a value perspective STAY ranks #6 in relative price target relative value (not a typo), and #8 in relative NAV relative value. Low ranks are better in our methodology, and these scores bring STAY in at #9 in our CORE REIT model and #8 in our Deep Value model, both firmly in the top decile.
Now in English. STAY finds itself in a unique position of having better momentum in both its price and fundamentals than peers, while trading at a lower multiple. Some of this valuation gap can be explained by quality. STAY’s hotels are not exactly Ritz-Carltons (their portfolio is more suited to the drive-to leisure customer as opposed to the business traveler), but the valuation gap between STAY and higher quality peers is massive. Based on 2022 consensus EBITDA estimates, STAY trades at 11.1x EBITDA, versus 19.2x for peers.
That’s an 8x difference for a portfolio with a much stronger fundamental outlook than higher quality peers. Peers which are more dependent on business customers, international travel, and large groups. Over the past 12 months, STAY’s consensus price target has actually increased 11.2%, while peers have seen their price targets fall by 3.7%.
Additionally, for the fourth quarter of 2020, STAY reported a portfolio-wide RevPAR decline of -9.4% year over year. This compares to peer Marriot (MAR) which announced RevPAR of -64.1%. Marriot trades at 19.3x 2022 EBITDA versus STAY again at 11.1x.
Think about that for a second. A Hotel company with total revenues that were only down 8% YoY in a quarter in which COVID cases were rising rapidly. As vaccines are administered at a faster pace over the next few months and US citizens become more and more comfortable with traveling, STAY stands to benefit meaningfully. Any kind of pent-up vacation demand in the US populace is likely to directly benefit this very inexpensive stock.
RISING INTEREST RATES: A FLY IN THE OINTMENT?
As you can probably tell by now, we are bullish on the US economy. More particularly we believe that a new economic cycle has begun and that we are in the early stages of a multi-year phase of earnings and economic growth. Vaccinations are accelerating, sentiment is improving, CEOs are beginning to make more decisions, and fundamentals in even the hardest hit REITs have stabilized and are improving. The stock market has agreed with our assessment, pushing re-opening stocks higher, and also (uh-oh) causing bond yields to rise rapidly.
Since October of last year, the yield on the 10-year Treasury has increased from a low of 66 basis points to 140 basis points as of today. This rapid acceleration has recently set some investors on edge, and predictably caused some to question the path forward for REITs. Can REITs work in an environment in which bond yields are increasing?
The short answer is yes, as evidenced by the REIT index moving higher along with bond yields since October. There is also ample evidence of REITs performing well over multi-year periods of rising rates. The mid-2000’s is an excellent example, as from 2003-2007 10y yields increased from a low of just over 3% to over 5%. REITs over this time period returned 19.3% on an annualized basis, almost double their average annual performance over longer time periods.
The more nuanced answer, however, is that the impact of rising interest rates differs massively by property type. Net Lease and Healthcare REITs, for instance, are much more sensitive to increases in interest rates than Hotels, Apartments, and Self-Storage REITs. This is primarily because property types with short lease durations (Hotels, Apartments, Self-Storage) can pass along inflationary pressures to their customers. Said another way, some REITs can raise their rents as the economy grows and interest rates rise, and some cannot. It’s hard to raise the rent on a tenant with a 10-year lease.
High duration property types have thrived in recent years as rates have moved steadily lower. As their size in REIT indices has grown, it would make sense that the REIT industry (as represented by the indices) has actually increased in duration (interest rate sensitivity). For passive REIT investors, this is bad news, as rising rates would now have an increased impact on returns relative to only a few years ago.
For active REIT investors, however, this is actually good news. In a re-opening economy with rates moving sustainably higher, these high duration, large cap, low volatility REITs will vastly underperform their more cyclical peers, allowing for extremely profitable pair trades. At Serenity we have shorted duration selectively over the past few months and will do so more actively as the cycle progresses and our models reinforce our macro-thesis. With more ways to short duration than ever, and a quantitative process for triangulating high duration names, opportunities will not be in short supply.
INVESTING WITH STYLE
The future is bright for investors with a robust process, as opportunities that have not been seen since 2009/2010 abound in the current market. Harnessing these ideas, however, requires original thinking, free from the tethers of the previous economic cycle and a willingness to embrace a new paradigm.
Style investing embraces this type of original thinking. It acknowledges that value reigns supreme in post-recession periods, that quality is less important when earnings are growing rapidly, and that duration is your enemy when economic growth is accelerating. Purely fundamental investors will not get to any of these conclusions, to their detriment… and to our benefit.
Don’t be a dork, invest with style,
Martin D Kollmorgen, CFA CEO and Chief Investment Officer Serenity Alternative Investments Office: (630) 730-5745 MdKollmorgen@SerenityAlts.com
**All charts generated using data from Bloomberg LP, S&P Global, and Serenity Alternative Investments
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