The build-out of data centers and 5G technology stands in contrast to the retreating retail and commercial real estate markets
The response to the novel coronavirus is adding a twist to the real estate adage that it’s all about location, location, location.
Even before the coronavirus crisis, investors were well aware that most brick-and-mortar retailers — and their landlords — were facing a dire threat from the rapid growth of online shopping.
But now that working at home has become a new norm for a sizable number of people, more is on the table. “Location” now has a different meaning because it’s no longer about a physical structure in an attractive area.
That’s because two areas of growth for real estate investment trusts, or REITs, are data centers that are benefiting from cloud-based collaboration and the work-from-home trend, and the rollout of 5G networks.
Threats to real estate
As office leases expire, corporate management teams will have an incentive and opportunity to save a bundle. Not only can they trim their physical office footprints, they may be able to do so at a significantly reduced cost per square foot, with lower overall demand.
So now instead of having one real-estate sector to automatically avoid (unless you are a professional with intimate knowledge of value plays within the space), you have two: retail and offices.
“You will see every CEO ask, ‘Do we really need all this office space?’ ” said John Traynor, chief investment officer of People’s United Advisors in Fairfield, Conn., in an interview.
Pacer Benchmark Data & Infrastructure Real Estate Sector EFT
The Pacer Benchmark Data & Infrastructure Real Estate Sector EFT US:SRVR takes a weighted approach to investing in data center REITs and other companies that store and transmit data, including owners of cell towers.
SRVR is up 3.5% this year through April 24 (including dividends), compared with declines of 11.7% for the S&P 500 US:SPX and 13.9% for the S&P 500 real-estate sector.
Here are all of its holdings as of the close on April 24:
You can click on the tickers for more about each company.
You will need to scroll the table to see all the data.
The ETF has a trailing 12-month distribution yield of 1.63%, according to FactSet. You can see on the table that some of the companies held by the fund have much higher yields, including some that are alarmingly high — indicating investors aren’t confident the yields will be sustained. These are also relatively small holdings in the portfolio.
The top three holdings make up nearly half the ETF. Equinix US:EQIX is a REIT focused on owning and operating data centers. Crown Castle US:CCI and American Tower US:AMT are REITs that own cell towers and lease space on them to multiple tenants running various communications networks.
One of the holdings with a very high yield is Iron Mountain US:IRM, which focuses on corporate information storage and disaster recovery. The stock is down 25% this year. Mitch Rubin, portfolio manager of the RiverPark Long/Short Opportunity Fund US:RLSIX US:RLSFX recently said he had shorted the stock because it continues mainly to store paper. “That business will be much smaller two years from now,” he said.
The Buffalo Discovery Fund’s Dave Carlsen on seven stock picks, from video-game makers to water-purification companies
You may have read stories about investment strategies tailored for down markets that have succeeded as the bull market in stocks ended this year.
The Buffalo Discovery Fund’s Dave Carlsen has steered the $1.4 billion fund to index-beating performance through thick and thin. The Discovery Fund BUFTX, -0.22% is rated four stars (out of five) by Morningstar and is typically invested about 70% in mid-cap stocks.
“The good thing about our process is we have already thought about the worst of times,” he said in an interview April 21.
“We want to identify long-term trends, make sure our companies can benefit from those trends, and manage to the trends, rather than to a benchmark,” said Carlsen, who started in the investment industry as an analyst in 1992.
We have compared the fund to two index benchmarks, and you can see its outperformance below.
Buffalo Funds is based in Mission, Kan., and has $3.5 billion in assets under management. Carlsen has been a portfolio manager of the Buffalo Discovery Fund since January 2004 and is now its sole manager.
Carlsen described a three-step investing process.
1. He and colleagues identify long-term innovative trends “that the market accepts,” and then pinpoint “market disrupters,” which are companies with growing market shares within those innovative industries.
“We look for trends up and to the right, rather than cyclical or mature companies,” he said.
2. Carlsen and his team use fundamental analysis to screen for companies with high profit margins, “scalable business models” and “balance sheets that can fund growth in good times and bad and a strong management team that can transform that secular opportunity into value for the shareholder.”
3. The fund picks investments based on stock selection. Carlsen and his team will look out five to seven years and establish best-case and worst-case scenarios with price-target ranges. “Best/worst provides a band of price targets that we think are possible. The band should be moving up and to the right, and the downside should too,” he said.
Here are seven examples of stocks held by the fund that Carlsen discussed:
Take-Two and Activision
Carlsen called Take-Two Interactive Software TTWO, +1.38% and Activision Blizzard ATVI, +0.04% “beneficiaries” of this year’s stay-at-home and social-distancing behavior meant to curb the spread of COVID-19. Shares of Take-Two have returned 4% this year, while Activision is up 13.5%. The broad indexes are down significantly, as you can see in the table below.
“They should put up good numbers this year. Even though we have had demand destruction elsewhere, this is an area where demand can hold up,” he said, adding that there is a longer-term “tailwind” for both video-game developers because of the coming upgrade cycle for Microsoft’s MSFT, -0.08% Xbox and Sony’s SNE, +0.62% PlayStation.
Chewy CHWY, +0.85% is known for providing excellent customer service and has “less than a 10% share of total pet spending, expected to be $85 billion in 2020,” according to Carlsen. The online-pet-food service, which provides all sorts of other pet supplies, is an obvious beneficiary of the COVID-19 lockdown. The stock is up 55% this year.
“Total pet spending grows by 4% to 5% each year. The primary driver is people are pampering their pets more than ever. Chewy is a very strong disrupter” to capture a significant portion of the move to online spending, Carlsen said.
SBA Communications SBAC, -1.11% owns wireless towers and leases space on them to multiple tenants using various technologies.
“Every time you make the tower more dense, in terms of customers, it becomes more profitable. Capex and maintenance cost for a tower are very low,” Carlsen said.
“It is a defensive business model, because customers sign long-term contracts. The contracts include annual price increase escalators,” he added.
One short-term disadvantage is the recently completed merger of T-Mobile US TMUS, -0.52% with Sprint. That means eventually less revenue on towers that had rented space to both companies. Then again, SBAC’s stock is up 27% this year.
The 5G network rollout is another long-term driver for the stock, Carlsen said.
DexCom DXCM, +2.13% makes continuous glucose-monitoring systems for diabetes patients.
“The advantage DexCom has is their accuracy is better than their competition. On the glucose monitoring side, they are the absolute leader,” Carlsen said.
The stock is up 47% this year, so Carlsen has trimmed his position. “The long-term potential is exceptional, but we think the current price reflects that. So we would buy on a dip,” he said.
Here’s a chart showing the five-year total return for Equifax EFX, -0.97% :
You can see the dramatic decline resulting from the customer data security breach disclosed in September 2017. This year the stock is down 5%. The COVID-19 shutdown has led to a decline in consumer-credit applications.
Carlsen stressed that Equifiax has been “transitioning to more of a data-analytics provider” from its traditional credit-reporting business. The company collects data directly from various entities, including banks and utility companies, allowing it to build a very accurate set of information about a person’s credit history, income, assets, bill-paying habits and even their employment status.
Equifax “differentiates itself by the quality of the data they collect. This verified data is worth more than competitors’ data,” Carlsen said.
Following a difficult period of elevated legal costs and efforts to rebuild its brand, Carlsen believes the worst is behind Equifax. Now during the coronavirus crisis there is “a demand void,” he said, but he believes the company ”is set to do very well when the economy recovers.”
Shares of Ecolab ECL, +0.14% are down 8% this year, but as a maker of hygienic-water-purification equipment used in various industries, it is a “good ESG” play for the long term, according to Carlsen. (ESG stands for environmental, social and governance.)
Ecolab also makes the supplies used by its cleaning equipment, which means an annuity stream from most customers.
“They have 10% of a $130 billion global marketplace. They are also known for a world-class sales force,” Carlsen said.
This year represents a challenge because so many of Ecolab’s customers in the hospitality and restaurant businesses have been shuttered. However, there is a long-term opportunity, as these and other industries focus even more on hygiene after the coronavirus restrictions are lifted.
“A lot of people think innovation is science, technology and health care, but we find it all over the place. This is an example of a materials company that is innovative and rewarding shareholders,” Carlsen said.
During 2020, the fund has held up well, with a 9.9% decline (after expenses) through April 23, compared with a 16.3% decline for the S&P 400 Mid Cap Index MID, -0.12% and a 12.8% drop for the S&P 500 SPX, -0.16%. Here are longer-term performance figures through April 23:
There’s a tendency for one year’s dogs to recover the following year
This has been an excellent year for U.S. stocks — so good, in fact, that among the S&P 500, only 57 have had negative returns. But it may be profitable to look among the losers for bargains.
Mark Hulbert recently pointed to a trend among stocks in the Dow Jones Industrial Average DJIA, +0.28% for one year’s worst performer tends to perform very well the following year. (Of course, he also warned that there have been exceptions to the trend.)
Looking at the year’s 57 losers among the S&P 500 SPX, +0.49%, 23 are down 10% or more (including reinvested dividends). Of course, a 10% drop for the best of this group may not seem like terrible performance, as stock prices are volatile. But it looks particularly bad when you consider that the S&P 500 has returned 30% this year through Dec. 18.
Among the 23 stocks, 10 have majority “buy” or equivalent ratings among the Wall Street sell-side analysts polled by FactSet. Here they are:
J.P. Morgan Chase has a reputation as the “best in class” among the Big Four U.S. banks, but Bank of America might be a better investment if you hold the stock for the next few years, according to Edward Jones analyst James Shanahan.
In an interview Oct. 17, Shanahan pointed to Bank of America’s BAC, +0.23% record $7.6 billion in share buybacks in the third quarter and massive investment in technology as catalysts for improving earnings performance and growing market share. (Buybacks lower the share count to boost earnings per share. They also reduce a bank’s excess capital, which boosts returns on equity.)
Shanahan said better technology will enable the four largest U.S. banks to continue taking market share from smaller competitors.
“The biggest banks are generating so much cash flow that they have the ability to make large and substantial investments in technology and leverage those investments into larger retail deposit footprints,” he said.
The Big Four are investing $10 billion to $12 billion a year in new technology, Shanahan estimated. This will “create a tech infrastructure smaller banks will not be able to compete with and will never catch up to,” he said.
Shanahan expects the Big Four to leverage their growing deposit relationships “across services as they take more share over time.”
A valuation play
At its current level of profitability, Bank of America’s shares should be trading higher, Shanahan argues. When discussing longer-term prospects, he said: “They are kind of catching up, but within a couple of years they should reach a level of profitability similar to J.P. Morgan Chase JPM, +0.37%. ”
That may seem a tall order. Let’s take a look at valuations for the Big Four, which also include Citigroup C, +0.32% and Wells Fargo WFC, +1.14%.
So Bank of America trades higher than Citigroup C, +0.29% and Wells Fargo WFC, +1.16%, but significantly lower, by both measures, than J.P. Morgan.
When Shanahan spoke of “profitability,” he specifically meant return on tangible common equity (ROTCE), which he said is “the measure we pay most attention to.” For banks, the denominator of that ratio is total equity, less preferred equity, goodwill and intangible assets, including loan-servicing rights.
Here are estimated 2019 returns on tangible equity for the Big Four, based on actual results for the first three quarters and Edward Jones’ fourth-quarter estimates:
Bank of America’s estimated return on tangible equity still trails J.P. Morgan’s by a wide margin, but it is also significantly higher than the estimates for Citigroup and Wells Fargo.
Shanahan actually has “buy” ratings on Bank of America and J.P. Morgan. He believes J.P. Morgan’s current premium valuation is justified because of “consistently stronger revenue and earnings growth, and industry-leading profitability,” he wrote in an Oct. 15 report. But the following day, he wrote that Bank of America’s price-to-tangible-book-value ratio of 1.6 was “unwarranted” because of its “strengthened financial condition and improved profitability.”
Wall Street’s view
Here’s a summary of opinion of the Big Four among analysts polled by FactSet:
Bank of American and Citigroup have majority “buy” ratings, with Citi the current favorite among analysts as a remedial play on its low valuation (see the first table above).
All four can also be seen as dividend plays. Here are current yields along with how much each company raised its dividend after annual capital plans were approved by the Federal Reserve earlier this year:
Economic outlook — a bright spot in third-quarter numbers
An interesting common theme Shanahan has observed this earnings season is continued strength in credit quality, particularly for U.S. consumers. Credit-card delinquencies typically increase during back-to-school shopping season, with non-performing card loans increasing through the holiday season, he said.
But despite some slowing of economic growth indicated by recent reports, third-quarter consumer-loan delinquencies “do not even reflect [normal] seasonal trends,” Shanahan said.
That is a big surprise and may point to better-than-expected strength for American consumers for some time.