2023-12-06 21:42:33 ET
Summary
- A few key developments have taken place since I last wrote about Simon Property ~3 months ago.
- Its stock price rallied sizably (which drove up its valuation) and the future direction of interest rates has become even more confusing in my view.
- At confusing times, it is especially important to seek guidance from basic principles.
- After examining it against Graham’s timeless principles on rates and defensive stocks, my conclusion is that SPG is still an attractive investment.
Time to go back to basics
I last wrote on Simon Property Group ( SPG ) about 3 months ago and argued for a bullish thesis on the stock. The key argument was that the market had overreacted to the pressure from interest rates and thus created an opportunity for contrarian investors. The good news is that the stock price has rebounded sharply since then (see the chart below) by about 14%, in contrast to the S&P 500’s 1.2% gain.
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However, the good news also created more confusion surrounding the stock, especially when combined with the development in interest rates since then. Firstly and obviously, the large price rally has changed its valuation multiples and thus the margin of safety needs to be reevaluated. Secondly and more importantly, the direction of the interest rates has become more uncertain than 3 months ago in my view.
Experiences have taught me two valuable lessons in investing. First, times of confusion create some of the best investment opportunities. Second, the more confusing the time, the more important it is to go back to the basics. The goal of this article is precisely to go back to the basics, all the way to the timeless principles that Benjamin Graham used to evaluate interest rates and defensive stocks.
In the remainder of this article, we will closely examine SPG against these principles. My conclusion is that SPG is still a good investment under current conditions despite the price changes and the next step of the interest rates.
Graham on Rates
Let’s start with the bigger picture – the interest rates. Due to recent data (inflation data, job data, et al), there are signs that the rate hikes could have reached an end. And both long-term and short-term rates (see the next chart below) have declined from their multi-year peaks correspondingly. While inflation may be showing signs of slowing, several factors could still cause it to pick up again and persist longer. Global supply chains remain fragile, which could lead to shortages of key goods and materials, driving up prices and contributing to inflation. There are several ongoing geopolitical uncertainties (war in Ukraine, the conflict in Middle East, and the trade tensions between the U.S. and China), which could disrupt the supply-demand balance (especially in the energy market) and drive up inflation.
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Good luck to you if you want to disentangle these factors and form a projection (or speculation) on the future direction of interest rates. And BTW, my projection/speculation, for what it is worth, is that rates have reached their peaks. Here, I will go back to Graham’s following wisdom (quoted from his classic The Intelligent Investor ),
Our basic recommendation is that the stock portfolio, when acquired, should have an overall earnings/price ratio—the reverse of the P/E ratio—at least as high as the current high-grade bond rate. This would mean a P/E ratio no higher than 13.3 against an AA bond yield of 7.5%.
As you see, a key point is that his wisdom does not involve guessing the future direction of rates. It only involves valuing stocks against the CURRENT interest rates – which of course makes perfect sense. Interest rates serve as the gravity of all asset valuation, which really means the gravity we are feeling NOW in my mind. With this, the next chart below shows the rates of Moody’s Seasoned AAA bonds . As seen, the AAA bond rates currently sit at around 5.28%.
FRED
Now let’s compare SPG’s valuation against the AAA bond rates. As seen in the chart below, in terms of dividend yield, the stock is yielding about 5.8% ~ 5.9%, slightly above the AAA bond rates. In terms of P/FFO (which I consider as the equivalent of P/E for REIT stocks) is in a range of 10.7x to 10.8x, translating into an FFO yield of almost 10%, far above the 5.28% AAA bond rates.
Thus, my conclusion is not that no matter where rates go next, SPG offers plenty of margin of safety for investors.
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REITs and defensive stocks
Obviously, Graham did not mean to recommend we buy every REIT with a dividend and/or FFO yield higher than the current AAA bond rates. We also need to look at other aspects of the stock. REIT stocks inherently have a more defensive nature than other sectors given their considerable physical assets. As such, I think it is only fitting to use Graham’s method of picking “defensive stocks” to further examine SPG.
His method is summarized below in a checklist. I compiled this checklist from his Intelligent Investor . More details are provided in our earlier article if you are interested.
- Is the company large, prominent, and conservatively financed?
- Does the company have a strong d ividend record? G raham considers “ a record of continuous dividend payments for the last 20 years or more ” is an important plus factor in the company’s quality rating.
- Has the company demonstrated an adequate level of Earnings Growth in the past? In Graham ’ s mind, a minimum increase of at least one-third in per-share earnings in the past ten years is adequate enough, translating into an annual growth rate of ~2.9%.
- Is the stock reasonably valued?
Many of the above aspects have been the topic of various SA articles including some of my previous articles. And to me, some items in this checklist are too obvious for SPG anyway. So here, I will just concentrate on the two aspects that are most relevant to this article: the growth rates and valuation after its recent price rallies.
First, let’s examine its growth. SPG does not have the most shining scorecard on this front as seen from the chart below. Its’ FFO growth rates in the past 3 years have been negative and in the past 5 years have been on average 1.29%, lower than Graham’s guideline of 2.9%.
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However, if we broaden the horizon a bit, its FFO has been growing at a CAGR of about 3% in the past ten years, meeting Graham's guidelines. Looking forward, I'm optimistic that its future growth rate could return to about 3% a year. My optimism comes from two factors. First, the company has been maintaining a healthy plowback ratio of about 1/3 historically. As seen in the next chart below, it currently only pays out about 60% of its FFO as dividends and retains the rest. Secondly, the company has a pretty competitive ROE (more on this later). A combination of a healthy plowback ratio and robust ROE has always been a successful recipe for growth in the long term for REIT companies.
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Next, let’s examine its valuation after the recent price rallies. Besides his wisdom on rates, the most crucial lesson I (and I assume many other investors too) learned from Graham can be summed up in 3 words: Margin of Safety (“MOS”). In my mind, MOS means more than a wide gap between price and value. It also means an acute consciousness of the uncertainties in the approach we use and the numbers we plug in. As such, we should always cross-check our analysis with at least two independent approaches.
Earlier, I assessed its valuation by comparing it to AAA bond rates. Here, I will form two more independent assessments: one with the Graham P/E and the other with the Graham number , both summarized in the table below.
As seen, the Graham P/FFO for SPG (which equals 8.5+2x growth rates without the percentage sign) is about 12.5x assuming a 2% growth rate (rather than the 3% I mentioned above). Compared to the market P/FFO of 10.8x, this represents a discount of about 13%. However, the Graham number shows are large overvaluation, which I will discuss more in the next section.
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Risks and final thoughts
As a popular ticker on the SA platform, most risks associated with SPG and the REIT sector in general have been the topic of many other articles. Here I will focus on a risk that is unique to this article. The above valuation discrepancy between different approaches (e.g., Graham P/E vs. Graham number) is a key risk in my view, accentuating the conflicting factors associated with SPG. In this case, I think the cause of the discrepancy might be reconciled (at least partially) if the ROE becomes part of the Graham number. As explained in my earlier article,
A key limitation in the Graham number is that it is based on the DOLLAR value of a company’s book (i.e., the book value, BV). In other words, it ignored the fact that each dollar in the book can have different earnings powers at different companies.
Normally, this won’t be an issue as many companies in the same sector have comparable ROEs. However, in the case of SPG, its ROE is just so much higher than the sector average. As seen in the chart below, its ROE currently hovers around the 65% range, higher than many of its peers (such as O, KIM, REG) by more than 1 order of magnitude. If ROE is used to adjust the Graham number (so that each dollar on its book weighs more in the calculation of the Graham number), then the valuation discrepancy would shrink or even disappear. However, such adjustment will inevitably involve an element of subjective judgment, which is a risk in itself.
To conclude, the goal of this article is to reexamine my bullish thesis on SPG. The reexamination is motivated by two developments: A) the sizable price change since my last article, which changed its valuation substantially, and B) the changes in interest rates since then. After examining both aspects following Graham’s timeless principles, my conclusion is that SPG is still an attractive investment opportunity despite the higher valuation multiples and regardless of future directions of rate changes.
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For further details see:
Simon Property: Graham's Wisdom On Interest Rates And REITs