Co-produced with Samuel Smith

Value investing in traditional stocks is very different from investing on a value basis in stocks backed by real assets. In short, many undervalued real asset firms have a unique opportunity to exploit the fairly easy liquidity of their underlying assets in the private markets to bridge the gap between price and value that is not shared by many other publicly traded firms. In this article, we will outline the difference and the exciting opportunity for real asset value investors.

Traditional Stock Market Value Investing

Value investing is defined by Investopedia as:

“An investment strategy that involves picking stocks that appear to be trading for less than their intrinsic or book value. Value investors actively ferret out stocks they think the stock market is underestimating. They believe the market overreacts to good and bad news, resulting in stock price movements that do not correspond to a company’s long-term fundamentals.”

Warren Buffett is the most famous of value investors, though his approach has shifted from focusing on book value to intrinsic value over the course of his career. He explains why in the following quote (emphasis added):

“If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long- term performance of the business may be terrible. I call this the “cigar butt” approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit. Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original “bargain” price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen…It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price…Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers.”

source

As usual, of course, Warren Buffett’s observations are spot on. While the book value method of investing sounds simple in theory, it is actually quite complicated in practice. This is due to two factors:

  • (1) Today it is practically impossible to buy a company below “true” book value unless it is circling the drain of bankruptcy, in which case the creditors are likely to realize that underlying value while equity holders get wiped out.
  • (2) Even if you could find one, you would need to purchase enough shares to take an active role in pushing the management to sell the entire firm or at least major business segments to realize the book value.

As a result, this is not a viable approach for the small individual investor today. This leaves us the option of focusing solely on intrinsic value. However, this too is quite complicated as there are many different ways of valuing a company and there are many variables to account for. This is particularly true with cyclical and international companies, which force investors to account for macro-economic and/or geopolitical factors in addition to the fundamentals of the business itself.

Furthermore, even if investors correctly determine that a company is trading at a steep discount, it can also take a long time for Mr. Market to recognize the intrinsic value in shares. Meanwhile, if a fairly illiquid and/or indivisible business underlies the stock (which is often the case), management has little it can do to meaningfully force the issue and bridge the gap between price and value, though it can (and often does) engage in some buyback and insider buying activity. The bottom line is that, while there is certainly still a place or intrinsic value-based investing in the stock market, it involves a great deal of uncertainty and patience.

Real Asset Stock Market Value Investing

In contrast, investing on a book value basis is alive and well in the publicly traded real asset space, making the value investing process much simpler for small individual investors. This is because with many REITs and other real asset securities, management teams have access to private market liquidity where they can make small or large acquisitions and dispositions fairly easily. They can therefore take a more active role in arbitraging the difference between price and value. At High Yield Landlord, we specialize in identifying and analyzing these sorts of opportunities in order to sift out the ones with the best risk-reward profile. The following are the most common situations that we encounter in our analysis:

#1 – Accretive Common Equity Raises

When a real asset company’s common shares trade at a premium to the net asset value of their underlying assets, management can issue additional shares which it can then recycle into acquisitions of additional assets. This practice – when properly executed – is an easy way to fuel growth as it is accretive for both cash flows (intrinsic value) as well as net asset value (book value) per share. It also has the additional accretive effect of improving economies of scale and improving a company’s network/critical mass competitive advantages as well. This is a very common strategy in the triple-net lease REIT space and has proven extremely effective at driving strong long-term shareholder performance as the examples below illustrate:

National Retail Properties (NNN):

Realty Income (O):

STORE Capital (STOR):

Data by YCharts

It is also popular in many other real asset sectors as well, including in infrastructure businesses such as the wildly successful Brookfield Infrastructure Partners (BIP):

#2 – Perpetual Low-Cost Preferred Equity

Another methodology that is popular is to sell perpetual preferred equity which can then be recycled as low risk debt/low cost equity into higher yielding assets. Preferred Apartments (APTS) has generated strong returns on equity for its common shareholders by aggressively implementing this strategy:

#3 – Sell Assets to Buy Back Shares

Real asset company management teams can also unlock value for value investors by selling assets into the private market to repurchase its shares that trade at a steep discount to net asset value. This is a very simple arbitrage technique that once again exploits public market volatility which is often more concerned with short term cashflow and macroeconomic sentiment whereas the private market tends to be focused on the quality of the property and its long-term potential. Companies that are currently employing this strategy to instantly add significant book value per share include Farmland Partners (FPI), Brookfield Property Partners (BPY), and Brixmor Property Group (BRX).

#4 – Buy Shares in Other Discounted Companies

A modified version of this approach is for companies to invest in shares from other real asset companies that trade at steep discounts to NAV. While riskier from a short term perspective as the shares go on the balance sheet and can suffer from significant stock market volatility, this strategy can be equally effective at creating long-term value for shareholders as buying back shares. Furthermore, it has the advantages of increasing diversification to a real asset company’s balance sheet as well as retaining easy liquidity with that capital. Companies that apply this in the real asset space include Brookfield Asset Management (BAM), UMH Properties (UMH), and Monmouth Real Estate Investment Corp (MNR).

#5 – Full-Blown Liquidation

Another condition that often leads to opportunity is for management to sell their entire portfolio to a larger consolidator to unlock value in a stock that is trading dreadfully below NAV. This is especially common when the company is plagued with structural problems and/or an unpopular model with the stock market but owns assets that are actually highly liquid and attractive in the private market. A recent example is General Growth Properties and a likely candidate for this in the near future is Front Yard Residential (RESI).

#6- Cash-Out Refinance

A final method for companies that trade at steep discounts to NAV and may lack liquidity in the private market but still have assets that lenders find attractive, is to encumber assets with long-term non-recourse mortgages. This strategy is really just a roundabout way of liquidating their assets by giving them access to the cash that they can use to unlock value throughout their portfolio, whether through buybacks, paying down higher-cost/higher-risk debt, buying back preferred shares, or investing in development/redevelopment projects. In a worst case scenario, they simply hand the encumbered properties over to the lenders and keep the cash they borrowed from them, essentially equating it to a disposition. As long as they are encumbering their properties at values that are greater than the implied NAV in the public market value of their shares, this practice is accretive to shareholders. This practice is especially popular among mall REITs such as Macerich (MAC), Washington Prime Group (WPG), CBL Associates (CBL), and PREIT (PEI).

Of course, none of these approaches are entirely risk free. A growth strategy based on selling equity at a premium to NAV in order to purchase more assets is entirely dependent on Mr. Market granting equity a premium to NAV. Additionally, it relies heavily on management making wise acquisitions and avoiding the temptation to engage in empire building to feed their ego and pocket books. This is especially crucial if the company is externally managed (where management makes a fee that is a percentage of total assets under management). One simply has to look at what happened to MLP space a few years ago to see how this model can go terribly wrong. Still, it is one of many options that real asset companies have at their disposal to create value for shareholders that other business models lack.

Additionally, selling assets to buy back stock comes with risks as well. Management may be tempted to sell off its highest quality properties first since they typically enjoy the best pricing/lowest cap rates in order to maximize accretion to cash flows while also adding NAV per share. However, this could prove dangerous by reducing the overall quality of the company. Additionally, as the company shrinks, its diversification and economies of scale decline as well. Therefore, while this practice can be lucrative if executed properly, it must be managed carefully to avoid taking on excessive risk.

The third approach is the riskiest as it requires investors to place considerably trust in management to pick the right stocks to purchase with their capital. While a buyback program requires significantly less trust since investors are obviously fine with buying that stock in the first place, a management team buying shares in other company’s without shareholder’s prior consent is a whole different game. This risk has been recently illustrated with the significant unrealized losses experienced in both UMH’s and MNR’s REIT portfolios as management teams invested in several REITs that have suffered dividend cuts and significant share price depreciation. On the other hand, until recently, these portfolios had experienced sizable outperformance and BAM has a solid record of capital allocation to traded securities as well.

Selling entire companies at a value closer to NAV than shares currently trade at is a great way to immediately unlock value for investors but is probably the most complicated and difficult way to approach it. It is also risky for investors to buy stock based on hopes for a company sale as it can often take a long time to come to fruition or may not even materialize at all.

Finally, while encumbering assets can unlock value, it should not be overdone as bond covenants cannot be violated and the more leverage placed on an investment, the riskier it inevitably gets.

Investor Takeaway

Intrinsic value investing, particularly using the discounted cash flow method, is still a very viable method for investing in the broader stock market today and can be quite lucrative. After all, Warren Buffett himself uses it. However, given how efficient markets have become and the ever-increasing complexity of modern multi-national corporations, especially in the large cap space, it is difficult to do this properly and carefully in such a way as to generate alpha over the long term.

However, as we outlined in this article, in the real asset space simpler lucrative opportunities for book value and intrinsic value investing abound as management teams can pull several different levers based on their situation to arbitrage differences between public and private market valuations. Of course, each of these situations come with their own set of risks, so careful analysis is still required and investors are encouraged to do their own due diligence before investing in any of them.

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Disclosure: I am/we are long MAC; UMH; MNR. 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.

Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.

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2019-09-05