2024-01-08 07:00:00 ET
Summary
- I credit my friend and fellow writer Chuck Carnevale for teaching me about the concept of value investing.
- In this article, I will highlight the importance of patience and a long-term mindset in value investing.
- I will also recommend two REITs that are in the so-called "sweet spot".
I always include a few mentors when I write new books and in my latest book, I reference my friend and fellow Seeking Alpha writer, Chuck Carnevale.
I met Chuck around fourteen years ago when I began writing on Seeking Alpha and he was kind enough to teach me how to become a value investor. As Chuck explained :
...if you're looking for short-term profits, value investing is not a strategy for you. To keep this clear in my own mind rather than calling it value investing, I like to think of it as business perspective investing.
In other words, I am not seeing myself speculating in a stock, instead, I see myself partnering as a shareholder in a wonderful business that I purchased at an attractive value. Therefore, I am thinking like a business owner not a day trader."
Over the last decade, I've become a student of value investing, always seeking to own stocks that I could purchase at a wide discount, or margin of safety. As Seth Klarman explained:
Few are willing and able to devote sufficient time and effort to become value investors, and only a fraction of those have the proper mind-set to succeed."
More words of wisdom from Chuck, also known as Mr. Valuation:
There are numerous ways on how value investing can pay off.
You can simply buy a great company that is growing at a sound valuation and then let the growth generate strong future returns.
Or, you can buy a slower-growing company at a significant bargain and make your money through P/E expansion as the undervalued stock moves back into alignment with fair value.
There are other ways that value investing produces good returns..."
Klarman adds:
The most beneficial time to be a value investor is when the market is falling."
I just reread Klarman's book, Margin of Safety , which I would encourage all of you to read. A few more sentences from Klarman:
The disciplined pursuit of bargains makes value investing very much a risk-averse approach. The greatest challenge for value investors is maintaining the required discipline."
I'll admit, when I was younger, I had no interest in discipline, and in fact, I was a speculator, always looking to get rich quickly. Here's how another Wall Street writer, Frank J. Williams explained speculation:
The quick profits are just froth. They arouse a fever in the blood and don't last. The worst thing that can happen to a new spectator is to make a lot of quick money on his first trade."
That's precisely why I limit my speculative holdings (to 10% of my portfolio) and ignore the so-called "sucker yields" and "value traps". As Klarman pointed out:
Being a value investor usually means standing apart from the crowd, challenging conventional wisdom, and opposing the prevailing investment winds. It can be a very lonely undertaking."
I'm honored to be the most-followed writer on the Seeking Alpha platform, and I hope that my "conservatism" pays off for all of my readers.
It's rare (or very unlikely) that you will see me touting a high yield stock like Annaly ( NLY ) or AGNC Investment Corp. ( AGNC ), both of which have witnessed numerous dividend cuts and have drastically underperformed.
I had a hard time grasping the concept of value investing because I could not recognize the fact that markets misappraise stocks in the short run, however Chuck Carnevale explained:
...at any point in time, the market can and will overvalue or undervalue a given company's stock without regard to fundamental values. As a result, these same investors lack the confidence to trust that fundamentals will inevitably rule over the long run."
As Chuck pointed out, "most unsuccessful value investors fail because they lack the patience to commit to long-term holding periods of time."
Researching REITs
Most of you know that I spend a lot of time researching REITs. As Seth Klarman wrote:
Investment research is the process of reducing large piles of information to manageable ones. Distilling the investment wheat from the chaff. There is, needless to say, a lot of chaff and very little wheat."
Our REIT coverage spectrum consists of over 150 companies, ranging from large S&P 500 names like Realty Income ( O ) to small-cap companies like Orion Office ( ONL ).
The reason I spend so much time researching REITs is because I want to achieve investment success and to help others (like Chuck did for me) reach financial freedom. As Klarman pointed out:
...today's research may be advance preparation for tomorrow opportunities."
So, in this article, I want to provide you with two REITs that our team has researched extensively and are in our so-called "sweet spot".
Essential Properties Realty Trust ( EPRT )
EPRT is a relatively unknown net lease REIT that I've been buying.
The company began trading in June 2018 and we picked up coverage almost immediately (August 2018). At the time (August 2018) EPRT was trading at $14.04 per share and since that time shares have returned over 135% (over 2x the S&P 500).
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EPRT was my top pick in 2019 , generating returns of over 80%.
And in 2020 I bought more shares in EPRT that generated another 75% return.
Without a doubt, EPRT has been one of the best investments of my career, and the key to the success has been due to value investing.
By focusing on fundamentals, I've been able to have the right mindset to recognize a bargain.
Today EPRT owns 1,793 properties (in 48 states) with a weighted average lease term of 13.9 years (the highest in the sector) with only 3% of rent expiring through 2026 (the lowest in the sector).
The portfolio consists of 363 tenants across 16 industries and importantly, the company obtains 98.7% unit-level reporting which gives the REIT a firm grasp on the financials of its tenants. 93% of cash ABR comes from service-oriented and experience-based tenants. Also, the portfolio is 99.8% leased (as of Q3-23) and the average investment per property is $2.6 million.
While other peers like Realty Income, Agree Realty ( ADC ), or NETSTREIT ( NTST ) seek to own properties leased to investment-grade tenants, EPRT is differentiated by its unit-level reporting that provides timely visibility into the health of its tenants and the need for expansion capital.
EPRT also maintains a disciplined capital structure with well-laddered debt maturities (average of 5.2 years and average rate of 3.6%). The debt is 100% fixed and the asset base is 100% unencumbered, with no secured debt. As of Q3-23, the company had $990mm of liquidity, a record since going public. EPRT is rated BBB- by S&P.
Since listing, EPRT has enjoyed dividend growth of 6.2% ('CAGR') and AFFO per share growth of 10% ((CAGR)). Analysts forecast 5% growth in 2024 and 6% growth in 2025. Also, the payout ratio is impressive (68% as of 2023).
Although not as cheap as the end of October 2023 ($20.84 per share), I find EPRT to be an attractive buy at $25.47. The P/AFFO is currently 15.4x compared with the normal multiple of 19.5x.
Prior to COVID shares traded around 19.5x and as seen below, we've modeled shares to return to that level by the end of 2025 which would result in annualized returns of 20%. The dividend yield is 4.5% with the lowest payout ratio in the net lease sector.
Highwoods Properties ( HIW )
HIW is another high-quality office REIT that I've been considering.
I'm most familiar with HIW based upon the fact that this North Carolina-based REIT is the "only" office REIT that did not cut its dividend during the Great Recession.
We began covering the company in 2013 and since our last update in August 2022 shares have underperformed:
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Again, sticking with the fundamentals, HIW has solid numbers that include a 28.5 million square foot office portfolio with 95% of the assets located in sunbelt markets. These markets include high growth cities like Dallas, Nashville, Raleigh, Charlotte, Atlanta, Orlando, and Tampa.
In addition, HIW's portfolio is 88.7% occupied with a weighted average lease term of 6.0 years. There's ZERO WeWork exposure and the top customers include well-known firms like Bank of America (4% of revenue), Asurion (3.5% of revenue), Federal Government (2.7% of revenue), and Metropolitan Life (2.6% of revenue).
HIW also has a strong balance sheet highlighted by 41.8% det + preferreds as a percentage of gross assets. 83.4% of NOI is unencumbered and only 9.5% of debt is secured (as a % of gross assets). HIW has investment grade ratings from Moody's (Baa2) and S&P (BBB).
As mentioned, HIW did not cut its dividend during the Great Recession, however the dividend has grown modestly (1.3% per year since 2019, with no growth in 2023). Earnings (AFFO per share) have grown by an average of 7% since 2019, with a negative growth forecast of -9% in 2023.
Analysts forecast negative growth of -3% in 2024 and -8% in 2025, with a return to positive growth of +8% in 2026.
In terms of valuation, HIW is trading at $23.04 per share with a P/AFFO multiple of 9.7x, compared with a normal P/AFFO of 18.2x. The dividend yield is 8.7% and is likely to be under pressure if the above-referenced analyst's estimates are close to accurate.
However, even with the negative growth estimates it appears that HIW will be able to navigate the current cycle without cutting the dividend.
Meanwhile, HIW's in-process development ($518 million) and core land bank ($3.7 billion of potential) provide catalysts (that value investors are always on the lookout for).
Recognizing that the office sector is still in the process of rationalizing in terms of valuation (supply and demand), I believe that the shares could conservatively land at $27.50 (11.9x) by the end of 2025 and our total return estimate is 20% annually.
In Closing
In 2023 I created our Quality and Value Tracker which helps to select the constituents for our REIT ETF.
As seen below, EPRT scores high on quality (89) and attractive on valuation (76). HIW scores average on quality (69) and very attractive on valuation (92).
The purpose of this Index is to assist our team with researching the universe for the best possible REITs to own recognizing that "the disciplined pursuit of bargains makes value investing very much a risk-averse approach" (Klarman).
As Benjamin Graham observed, "you are neither right nor wrong because the crowd disagrees with you. You are right because the data and reasoning are right."
As he wrote in The Intelligent Investor, the value investor's purpose is to capitalize upon "a favorable difference between price on the one hand and indicated or appraised value on the other."
Batter up!
Note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.
For further details see:
Waiting For The 'REIT' Pitch