Value Play: Equity Commonwealth (NYSE: EQC)

This week on December 16^th, the Federal Reserve is set to raise interest rates for the first time in more than nine years, so . . . I’ve decided to recommend a real estate investment trust (REIT).

I know what you’re thinking: why would I recommend a REIT when REITs are considered interest-rate sensitive? Good question, but my answer is also good. First off, the office REIT that I am recommending as this month’s Roadrunner Value Portfolio Front Runner – Equity Commonwealth (EQC) — doesn’t pay a dividend, so it acts like a growth stock as opposed to a fixed-income security.

Secondly, REITs actually perform quite well in rising rate environments, despite the “common” (but wrong) wisdom that they don’t. The reason: REITs are not “fixed” income vehicles, but grow their revenues with rising rents of existing leases, new renters, and the acquisition of new revenue-producing properties, so REITs possess strong equity characteristics that flourish in times of economic growth – which is the only environment under which the Federal Reserve decides to raise interest rates:

• “In the 16 periods since 1995 when interest rates rose significantly, Equity REITs generated positive returns in 12.”
• “Starting in June of 2004 and ending in August 2006, short-term rates were hiked 17 times from a starting point of 1.00 percent to a peak of 5.25 percent. Over this two-plus year period, GDP grew steadily and commercial property values increased. REIT investors were rewarded with more than a 60 percent return over this time frame, beating the overall stock market’s 20 percent rise.”
• “While REIT returns are tied to interest rate trends in the short term, we found that over longer time periods, this correlation is weak. What really matters is dividends paid and the growth of cash flow.”

As the investment bank Lazard recently wrote in regards to REITs, the economic fundamentals of real-estate investment remain strong despite the hysteria over rising interest rates:

Real estate fundamentals, which have been lost in the macro noise around interest rates, remain solid and are showing greater stability than broader equities. In contrast to the last two earnings periods for the S&P 500 Index, which have been difficult (with the worst third-quarter revenue and earnings results since 2009), REIT earnings growth has remained in the high single digits, primarily driven by same-store net-operating-income (NOI) growth of approximately 4.8% among the core sectors.

Further, with 4.8% same-store NOI growth expectations in 2016, REIT earnings growth should be in the high single digits. Earnings expectations have not changed very much over the past few months (with the exception of some slowdown in hotel and regional mall growth). Year to date, the expectation of earnings stability has been reinforced through REIT dividend increases. Through the end of November, well over 100 US real estate companies have increased dividends this year in excess of 6% year-over-year dividend growth.3 Current expectations are for the REIT sector to increase dividends by approximately 7% next year.

When trying to make money in the stock market, a good strategy is to piggy-back on money managers who have proven able to reward shareholders over long periods of time by allocating capital efficiently for above-average rates of return. This investment philosophy explains why people invest in Warren Buffett’s Berkshire Hathaway and Prem Watsa’s Fairfax Financial. Honest and competent management is a critical component of my Roadrunner stock-selection methodology. In the real-estate space, there is no better REIT manager than Sam Zell, the Chicago mastermind behind three wildly-successful REITs: (1) apartment REIT Equity Residential (EQR), (2) mobile home REIT Equity LifeStyle Properties (ELS), and (3) office REIT Equity Office Properties (sold in 2007 to private equity firm Blackstone for $38.9 billion).

Billionaire Sam Zell is the current Chairman of Equity Commonwealth, which is an office REIT he plans to transform into the next iteration of the high-flying Equity Office Properties he sold for top dollar to Blackstone in 2007. He was appointed Chairman in May 2014 after joining a group of dissident shareholders with a 10% ownership stake that initiated and won a proxy fight to remove the management team of Barry and Adam Portnoy, who had been accused of conflicts of interest, siphoning cash from the REIT in favor of their privately-owned real-estate management company.

In August 2014, the company’s name changed from CommonWealth REIT to Equity Commonwealth. Adding the word “equity” may seem inconsequential, but it actually was tremendously meaningful for company’s future direction as Zell explained:

This name change reflects a new chapter for the Company. In keeping with the other ‘Equity’ companies, Equity Commonwealth will operate with an entrepreneurial culture, where the interests of all stakeholders are aligned, focusing on long-term value creation for Equity Commonwealth’s shareholders.

Maximizing long-term shareholder value required that the company, which was in horrible financial shape, stop paying dividends – a bold step for a REIT whose investor base expects to receive income payments. The company had too much debt and too many mediocre, low-rent properties (i.e., class B and class C instead of the top-rated class A) in mediocre, slow-growing suburban locations. Zell’s rehabilitation plan is three fold: (1) sell off the class B and class C properties in suburban locations at top dollar to reduce debt, (2) save cash flow by eliminating the dividend, and (3) reinvest the cash from property sales and dividend savings left over after debt reduction to invest in class A properties in major urban centers.

Now is a great time to sell properties because the commercial real estate market has been characterized by smart people (including Boston Fed president Eric Rosengren) as in a “bubble” of unsustainably-high valuations. One of the valuation measures of commercial real estate is the capitalization rate, which is defined as net operating income divided by property asset value. Historically, the normalized “cap rate” is around 10%, whereas the average cap rate recently has been closer to the 6%-8% range (page 3). Zell’s nickname is the “grave dancer” because he loves to profit from other people’s financial mistakes, whether it be buying undervalued assets or selling overvalued assets. As one real-estate industry veteran explained last year:

The investment-sale market for B and C quality product is as aggressive as it’s been in the last 10 years, which results in excellent proceeds for selling stuff that you couldn’t give away four years ago.

Take a look at Equity Commonwealth’s November investor presentation to see the tremendous progress that Zell has made in transforming the company’s balance sheet for the better:

• Sold $1.9 billion year-to-date; weighted average cap rate in the low-to-mid 7% range. Another $1.1 billion in property sales planned (slide no. 6)
• Decreased liabilities and preferred equity by $1.4 billion since March 31, 2014, which reduced net debt to adjusted EBITDA from 6.1x to 0.6x
• Current cash balance of $1.8 billion

The investment thesis in Equity Commonwealth is based on Zell’s management and capital-allocation skills, not on current financial results – other than an improved balanced sheet. Consequently, I am not going to discuss the current income statement other than to say it shows losses which are to be expected during this time of restructuring.

Equity Commonwealth’s current real-estate portfolio after the recent property dispositions is 67 properties which, combined with the $1.8 billion in cash, yields a net asset value (NAV) per share of at least $32-$33, which means that EQC’s stock price of $26.85 amounts to a substantial discount from NAV of almost 20%. In fact, the interest-rate hysteria has caused many REITs to trade at discounts to NAV, which is leading savvy real-estate investors to consider takeovers of REITs. At the top of the list of preferred takeover candidates must be Equity Commonwealth given its stellar balance sheet.

Bottom line: While most REITs continue to be overleveraged and continue to buy properties at nose-bleed bubble prices, Sam Zell and Equity Commonwealth are doing the exact opposite. I agree with the famous value-investing shop of Wallace Weitz that:

Equity Commonwealth is uniquely positioned in the REIT world. EQC sits in an enviable position of having significant liquidity and peer leading leverage metrics. Given the longevity of the current economic recovery, frothy real estate market conditions and the prospects for higher interest rates, we believe EQC is well positioned and properly incentivized to take advantage of potential market weakness and increase NAV per share over the long term.

Equity Commonwealth REIT is a buy up to $32.50; I’m also adding the stock to my Value Portfolio.

Value Sell Alert

To make room for Equity Commonwealth, Roadrunner is selling:

• Sanderson Farms (SAFM)

I’ve stubbornly stayed loyal to this chicken producer for 17 months because its stock offers low correlation with virtually allprice other stocks in the Value Portfolio and has an extremely low EV-to- EBITDA valuation below three times. What I should have paid more attention to was the devastating impact bird flu would have on chicken prices and the extremely high short-interest-to-float ratio on the stock of 39.9%, signifying tremendous bearish skepticism among short sellers, who are typically an intelligent group of traders and part of the “smart money.”

On December 3rd, the stock shot up almost 9% — the largest one-day move in more than three years (since August 28, 2012) — on news that a nondescript Hong-Kong-based research firm called CLSA Americas upgraded the stock. The analyst asserted that “the sharpest declines in chicken prices were behind us” and that “a bottom may be forming” in the stock. Interestingly, this upgrade was unaccompanied by any increase in earnings estimates by other analysts, with the consensus earnings estimate for full-year 2016 amounting to a 44% decline from 2015 levels. 

Granted, the one-day price jump back in August 2012 was the start of a multi-month rally, but that is simply one data point and not sufficient to offer assurances of a similar rally this time around. I’m going to take advantage of this undeserved price jump and sell the stock before reality returns and the stock stumbles back down. On December 7th, the World Trade Organization (WTO) ruled against the U.S. government in its attempt to require labeling of foreign-produced beef and pork. Such labeling would have deterred U.S. consumers from buying foreign beef and pork, which would have probably resulted in the consumption of more chicken. With the WTO ruling, chicken processors will face more competition from other protein sources. Sanderson’s fourth-quarter earnings are scheduled to be released on Thursday, December 17th in the morning and I don’t want to stick around for the likely depressing results.

Sanderson Farms is being sold from the Value Portfolio.

Momentum Portfolio is Being Phased Out

Ever since the first issue of Roadrunner Stocks, I have been a strong advocate for a diversified portfolio of both value stocks and momentum stocks. A 2013 research paper entitled Value and Momentum Everywhere by hedge-fund manager Clifford Asness concluded that a portfolio consisting of 50% value stocks and 50% momentum stocks outperformed both a value-only and momentum-only portfolio by significant margins. In addition, the momentum formula I have used to select the best momentum stocks (3-12 month price appreciation) has been proven effective by several financial academics, including Robert Novy-Marx and Amit Goyal.

Despite all of this, the severe price volatility of momentum recommendations (particularly the downside variety) has deterred most Roadrunner members from investing in the momentum stocks recommended. In our recent survey of members, more than half (59.1%) of the 44 respondents answered that they didn’t own a single stock out of the entire 20-stock momentum portfolio. This was a surprising result considering that more than half of these same survey respondents answered that they considered themselves investors of both value and growth stocks, rather than strictly value investors.

Granted, growth stocks and momentum stocks are not the same thing and 44 respondents is not a large sample size, but the survey results nevertheless leave me to believe that my time would be better spent focusing solely on value stocks.  Fundamental analysis of corporate financial statements is my specialty and value investing in the style of Warren Buffett is my passion, whereas momentum investing is more mechanical and unthinking and, frankly, something that any investor can do on his own without expert guidance. In my articles What is a Roadrunner Stock? Part 1 and Part 2, I am referring to value stocks, not momentum stocks.

Furthermore, momentum is a fleeting phenomenon, one that requires frequent trading of the entire portfolio because once price momentum on an expensive stock is lost, the stock price can decline dramatically and damage overall performance. In Clifford Asness’ research paper, he adjusted the momentum portfolio in its entirety every month. In contrast, I have been buying and selling only one stock per month in the momentum portfolio, even if more than one existing portfolio holding had lost momentum. The result is that a monthly newsletter like Roadrunner cannot mimic Asness’ momentum results because it cannot execute the momentum strategy in the frequent-trading style necessary to be successful. Consequently, even though momentum investing adds value to an investment portfolio if executed properly, the momentum component cannot be done justice by Roadrunner‘s monthly newsletter format and should pursued through some other investment vehicle such as do-it-yourself investing or a mutual fund/ETF (e.g., MTUM, PDP, DWAS, AMOMX, ASMOX).

To quote a wise man:

“In the short-run, most of us simply cannot endure the pain that momentum investing strategies impose on our portfolios and our psyches. It is simply too difficult. Furthermore, for those in the investment advisory business, providing a strategy with the potential for multi-year underperformance is akin to career suicide.”

For the next three months, I will continue to maintain the momentum portfolio on the Roadrunner website, but without stock updates except for buy/sell/hold advice.

Best regards,

Jim Fink