ICF Realty Majors a bargain at half the price

Barron's recently published an interview with Marty Cohen of Cohen & Steers (CNS), an asset manager that specializes in REITs and Utilities. The subject of the interview was REITs. Marty Cohen carefully danced around the subject of the massive bubble in large cap equity REITs. The bubble is nicely captured by the iShares Cohen & Steers Realty Majors (ICF). This nifty chart shows the staggering market performance of index of the top 30 equity REITs.

The Negative Margin

The Realty Majors ETF is currently yielding 3.14%, which is a noticeably less than the current T-bill rate of 5%. In order to justify such a high valuation, the index REITS must register FFO growth in the 10% range in 2006 and beyond. This is much higher than the historical CPI+1-2% FFO growth rate of stable equity REITs.

REITs have generally traded at a 150-300 basis point spread over the treasury yield. The positive spread was compensation for the higher risk of real estate cash-flows. By nature REITs have exposure to tenant credit risk as well as external economic risks of the varying demand for retail and office space. Even taking into account the positive benefits of internal portfolio diversification, equity REITs cannot be safer than treasury bills or online savings accounts. New investors have a negative margin of safety.

Astute REIT managements use their own overvalued shares as currency to acquire slightly less overvalued REITs.

Recent M&A mania in REITspace is driven by very cheap capital. This cheap capital comes from two sources. There is exogenous capital from private equity buyers fortified with cheap loans. And there is endogenous capital, from stock swaps, as astute REIT managements use their own overvalued shares as currency to acquire slightly less overvalued REITs. The recent proposed takeover of Glenborough Realty (GLB) by a syndicate led by Morgan Stanley is an example of exogenous capital. The silly takeover of Reckson Associates Realty (RA) by SL Green realty corp (SLG) by an all stock deal is a fine example of internal trading of paper for paper.

Probably the best description of what is happening and has happened in REITspace comes from Richard DeKaser, Chief Economist at National City Corp's (NCC) Economic Office. Paraphrasing from the June 2006 Financial Market Outlook, talking about the residential housing market:

Under ordinary conditions, which are implicitly embedded in most statistical models, rising prices subdue demand, all else being equal. But in a bubble the opposite is true; rising prices not only fail to subdue demand, they actually excite it. [REIT Investors] make purchases not based on relative value propositions (e.g. [relative asset returns]) but on the belief that future price gains will reward current purchases. This self-fulfilling proposition then builds on itself. That is, until it doesn’t, and the economics profession isn’t especially strong at pinpointing these tipping points.

With wisdom comes silence.

To be successful at investing, you have to constantly reexamine your starting assumptions with time. This is because you are constantly confronted with choices. Over time you begin to realize that not all choices are of equal importance and that for many important choices there is really no conclusive information to inform your decision. So you stay silent and watch.

There is always backchatter about short term macroeconomic conditions and what implications that should have for your investments. People hate to be in an informational vacuum, so they listen to the noise in the circuit, even if it has no meaning or useful information. Much careful thought and agony goes into carefully positioning investment portfolio's to capture macroeconomic trends. Thanks to ETFs it is now easy to create focused portfolio's to capture almost any investment theme.

This concern has almost no impact. It is a distraction from the real challenge which is finding cheap and safe investments. In order generate portfolio alpha from macroeconomic insights, you have to satisfy a several different conditions.

• Your conclusions have to be substantially different than the market opinion.
  
• You have to be right about your macro predictions.
  
• The insight has to be actionable.
  

The first condition is critical. If you read about it in Barrons, the New York Times, or the Wall Street Journal it is too late; everyone else knows about it too. Whatever information is out there is already priced in. Because it is priced in, there is no excess risk adjusted return if you are in accord with the consensus.

Let's take the nasty outlook for homebuilders (XHB) as an example. If you agree with the housing bubble shopocalypse scenario, it doesn't do you any good because everyone else knows about it as well. Let's say that you think the housing collapse will be 3% worse than the market expects, it's still not enough to take actions that will generate excess returns above market noise. Given that the implied volatility of the S&P 500 (VIX) is currently about 12%, your predictions have to be at least that much different from the market consensus to have serious alpha impact. Therefore agreement with the crowd, or even agreeing with it more intensely, does not lead to excess return. You have to be able to disagree, and greatly disagree to have a palpable difference.

Having correct macro insights is sort of obvious, except for the fact that for any given scenario you can get several interpretations, and usually the average of all them is priced in. As such, usually everyone is partially right and partially wrong and it comes out a wash. That zone of indifference within 1SD of the mean estimate is quite large and usually encompasses most opinions. Without pricing inefficiency, excess returns are impossible.

Finally your insights have to be actionable. For example, I think that there will be big impact from a tightening phase in the credit cycle. Sadly there isn't much I personally can do with this insight, since I don't have positions in high yield bonds or leveraged equities. Taking a prudent approach means you don’t have to worry about things that are unimportant to thoughtful investors.

So the long and short of it: is to keep your eye on that fat pitch, and do not get distracted by the cheering and booing of the fans.

A brief refresher

Willis Stein & Partners has retained Evercore Partners (EVP) and Lehman Brothers (LEH) to help evaluate a possible sale of Ziff Davis Holdings, a New York-based publisher of titles like PC Magazine, eWeek and CIO Insight. Ziff Davis reported $5.7 million in EBITDA for Q2 2006, on revenue of $45.2 million. Willis Stein acquired the company in 1999 for $780 million from Softbank.

Just a reminder that it is important to be price-sensitive.
Tip of the hat to Private Equity Week daily PE Wire

Shareholder Friendly

Bloomberg has a fascinating article today (by Caroline Salas and Aparajita Saha-Bubna) on investment grade bonds that are getting hurt as companies increase leverage to finance special dividends and stock buybacks. The conversion of equity into cash for shareholders reduces the amount of junior capital supporting the senior bonded debt. From an academic finance perspective, this is an example of the shareholder/bondholder conflict as shareholders who control the company seek to maximize returns for themselves vs. keeping the company securely capitalized for the benefit of bond owners.

There are several reasons for this recent jump in shareholder friendly activity. One reason is the natural desire of boards and management to create tangible shareholder value: especially value that can be seen in the short term. Shareholders can directly perceive dividends and sense the effects of share buy backs. The virtues of a conservative capital structure are more subtle and remote. However investors must keep in mind Benjamin Graham’s observation that the junior capital can never be safer than senior capital.

A second reason is the growing influence of activist hedge funds and the "private equity put". Simply put, there are noisy, greedy and impatient investors with money out there. Hedge funds tend to seek corporate actions that lead to immediate returns. Private equity folks look for underleveraged and under priced companies that they can lever up and flip for a fast buck. Both hedge funds (LBO artists) can be mollified (deterred) by increasing stock prices, and making the company less suitable for asset stripping or a takeover.

Thanks to a glut of private equity capital, the threat of takeovers and buyouts is at levels not seen since the 1980s, and so the corporate governance focus is shifting to tangible value creation, at the cost of an increase in risk. Whether real value is created on a risk-adjusted basis is yet to be seen.

Springtime for GNC

Today, GNC has cancelled its proposed IPO. According to Renaissance Capital analyst Melanie Hase, GNC's sponsors wanted to price the shares between $16 and $18, but IPO investors were only willing to pay $13 to $14.

The post IPO GNC would have large and notable defects in its capital structure. Since the beginning of 2006, the IPO market has cooled to post-LIPOsuction IPO's. The Post-LIPOsuction returns have been unattractive (Sealy (ZZ), DynCorp International (DCP), Burger King (BKC). This has even lead to some notable pre-IPO flameouts such as Chart Industries (GTLS).

Everyday I wake up to be new

The current Friday linkfest on Abnormal Returns, is partly about two problems that are linked. The first problem is that active investing is very hard. The second problem is that quantitative analyses aren't as helpful as commonly thought.

Why is it not helpful? Mostly because the economic past is not very useful in predicting the near future. And so data about the economic past is not very helpful in predicting the near future.

Present conditions are hopelessly different than the past. Each year there is a different economic situation that has been preceded by different economic history, different market psychology, and different market participants. 1930 was preceded by 1929, which was preceded by 1928. Each year is very different from the others the preceded and followed it. In a situation where each year is an outlier, the average can be very deceptive.

To quote Gnarls Barkley, from the song "Feng Shui", the economy is:

To big to be boxed in/
it bobs and weaves/
it evolves, it solves/
it gives and receives/

Aircastle AYR in the sky with dividends

Of all the IPO's this week the most interesting is Aircastle Ltd (AYR), Air Castle was started by Fortress Investment Group, to participate in the lucrative world of aircraft leasing.

In October 2004, Fund III and certain coinvestors formed an aircraft investment and leasing company to take advantage of attractive buying opportunities within the aviation sector. Particularly among the major US carriers, competition from discount airlines coupled with high fixed costs and soaring fuel prices had driven operators into bankruptcy. As part of restructuring, many airlines underwent cost cutting programs and fleet rationalization using bankruptcy to return aircraft to lenders and lessors. Aircastle’s strategy is to acquire high-utility planes at attractive risk adjusted yields, lease those planes primarily in growing markets outside the US, and actively manage the assets to minimize credit and operating risks. Fortress’s thesis is that through detailed analysis of each plane and the use of modest leverage, Aircastle can generate attractive cash flows with limited volatility.

The first is that the company’s business model of financing leases via aircraft lease securitizations greatly reduces the amount of equity capital employed. Aircastle's business model is that of an Aircraft REIT. The core idea is to buy aircraft, put them on the street, while financing them with a self-liquidating securitization trusts.

Aircastle Ltd operates in the tax haven of Bermuda and so does not pay tax at the corporate level. Not paying corporate tax means more earnings are available for distribution and reinvestment. Aircastle does intend to pay dividends, and given that Fortress owns 80% of AYR, public shareholders can expect to get paid generous dividends. Just like those from Newcastle Investment Corp (NCT), Fortress' mortgage REIT. Currently Newcastle spits out $2.60 in dividends per share equivalent to a 9.80% annual yield.

Since NCT's IPO in 2002 investors have received a total return of 157%, equivalent to 29% annualized. No wonder Aircastle Ltd's (AYR) IPO opened at $27.45 a share, well above its offering price of $23.

DEI Douglas Emmett and the billion dollars. A REIT story.

The IPO of Douglas Emmett (DEI) will be the largest equity REIT IPO of 2006. DEI specializes in owning Class A office properties in downtown Los Angles, California and Honolulu, Hawaii. In DEI's own words:

We are one of the largest owners and operators of high-quality office and multifamily properties in Los Angeles County, California and have a growing presence in Honolulu, Hawaii. Our presence in Los Angeles and Honolulu is the result of a consistent and focused strategy of identifying submarkets that are supply constrained, have high barriers to entry and exhibit strong economic characteristics such as population and job growth and a diverse economic base. In our office portfolio, we focus primarily on owning and acquiring a substantial share of top-tier office properties within these submarkets and which are located near high-end executive housing and key lifestyle amenities. In our multifamily portfolio, we focus primarily on owning and acquiring select properties at premier locations within these same submarkets. We believe our strategy generally allows us to achieve higher than market-average rents and occupancy levels, while also creating operating efficiencies.

Douglas Emmett owns about 21.5% of the Class-A office space in its Los Angeles submarkets and 13.2% of the office space in the Honolulu central business district [CBD]. Because of the limited supply of desirable properties in such desirable locations; Douglas Emmett can charge above market rents while still keeping high occupancy. This is important

Given the recent strong market interest office REITs, this IPO should do very well. Office REITs, with exclusive desirable properties, such as Manhattan based SL Green (SLG), have been trading at a premium to the equity REIT sector which is itself trading at all time high valuations. DEI is the west coast SL Green (SLG). Investors in SL Green have done very well for themselves. The stock market assigns a very real premium to REITs owning top-notch CBD office properties.

Douglas Emmett Inc (DEI) is being structured as an UPREIT. The publicly traded REIT itself will own the General Partner interest, and a portion of the limited partner interests of Douglas Emmett Properties LP, which is the underlying operating partnership that owns the properties.

Blazac noted that behind every great fortune there is a crime. To modernize Balzac's observation, replace fortune with "capital structure".

Because DEI is not currently a living REIT, all sorts of formation transactions, financing transactions, and pre-REITification clean up must happen before the IPO. These greatly complicate the prospectus. IPO proceeds will be used to pay a combined cash and equity consideration for the assets (properties) of various historical operating companies and to integrate them into the operating partnership.

Most of the numbers haven't been worked out yet, but they all assume an IPO of at least $1 Billion. Expect further developments as DEI gets closer to its IPO.

Water Industry pumping on all cylinders

2006 is going to be a banner year for the water industries. Major players are reporting earnings this week, and the future looks bright indeed. Previous posts have outlined the case for investing in the Palisades Water Index ETF (PHO), as well as some global water stocks with US listed ADRs. Several key players announced earnings on August 2 2006, to good reception. Taken as whole, the earnings outlook for the industry is good, however it is very important to be choosy when to comes to valuations.

• Walter Industries (WLT), the less famous parent of Mueller Water Products (MWA) reported strong results. On August 2 2006, shares jumped up $5.16 (11.75%) for WLT, and $1.17 (7.63%) for MWA. Walter Industries is now an officially a stub company. Mueller Water Products has market cap of 3.64Billion. Walter Industries which owns the remaining 75% of Mueller Water Products is worth a mere $2.13B. So much for efficient markets.
• Watts Water Technologies (WTS) shares also jumped. Up $5.16 (17.99%) on reports of massive earnings growth. Income from continuing operations for the first six months of 2006 increased by $11,245,000, or 43%, to $37,630,000, or $1.14 per share, compared to income from continuing operations for the first six months of 2005 of $26,385,000, or $0.80 per share.
• Badger Meter (BMI) reported record sales for the second quarter, and which leading naturally to record sales and earnings for the first half of 2006. Earnings came under pressure from increases in the price of copper and zinc.
• Aqua America (WTR), the US's largest publicly traded water utility beat analyst estimated by a penny, reporting 0.17 cents vs 0.16 cents. Most importantly the company's Board of Directors voted to increase the quarterly dividend by eight percent to $0.115 per share -- an annualized rate of $0.46 per share. This is the eighth consecutive year in which Aqua America has increased its dividend above the stated five percent target and the 16th dividend increase in 15 years.

Growth Investing :: Recapitulation Part III

In the first and second parts of this series on growth investing we looked at two elements that are hallmarks of a successful growth company.

1. The ability to grow turnover (sales generated by each unit of operating assets)
2. The ability to earn excess economic profits.

Using just these two ideas we can see that the ethanol industry is not populated by growth companies. Many companies in the industry are experiencing rapid sales and profit growth. Yet they are not real growth companies creating long term value. A rising tide is lifting all boats, but none of the boats is getting bigger

The first reason is that a pure play ethanol producer [Pacific Ethanol (PEIX) Aventine Renewable Energy (AVR), VeraSun Energy Corp.(VSE) etc] cannot grow total asset turnover. The business model for an ethanol company is that you put X units of carbohydrates in, and get Y units of ethanol out. There is no way to increase the efficiency of this process. It is physically limited by the ability of yeast to ferment glucose into alcohol.

Distillation and fermentation technologies have been under development since 700 AD. It is reasonable to assume that no distiller has proprietary technology which gives it a lasting competitive advantage over other producers.

If you want to get more ethanol, you will have to invest in larger facilities. These companies cannot growth revenues without additional capital expenditure, and that increase is always proportional to the investment. None of these companies can increase the return on operating assets over time. They will never see the rewards of growth on growth.

Growth on growth what growth investing is really about, the ability to invest/reinvest at an increasing rate of return. Imagine a savings account earning 5%. Now imagine another savings account earning 5%, but with the interest rate rising each year. Clearly the second account is better, and will outearn the first account.

Because ethanol is fungible (a fancy way of saying that ethanol from one company is interchangeable with ethanol from another), ethanol distillers operate in a competitive market. Every supplier is the same, and the sale goes to the lowest bidder. You can’t raise prices in such a market. Over time the ethanol market will settle into an equilibrium in which no excess economic profits are earned.

The combination of an inability to increase return on operating assets and eventual maturation into a competitive market without pricing power, means that companies in the ethanol sector will not accomplish real excess growth.