PERFORMANCE – Serenity Alternatives Fund I returned -0.40% in January net of fees and expenses.
SHORT SQUEEZE – Frenzied rallies in Gamestop, AMC, and other highly shorted stocks bled into the REIT market in January. While many hedge funds suffered, Serenity survived and is set to thrive.
CORONAVIRUS – Doom and gloom headlines obscure positive momentum in recent COVID-19 data. The untold story is that herd immunity may be closer than many think.
CYRUSONE (CONE) – A best idea re-iteration. Why the turnaround at CyrusOne may gather momentum in 2021.
“This is madness!
– King Leonidas, 300
Has the market gone mad? Last week a mob of faceless internet warriors pushed an obscure video game retailer into the living room of mainstream America. Along the way they took down a variety of multi-billion-dollar hedge funds and seemed to turn the edifice of Wall Street firmly on its head. Trading was frenzied, emotions were high, and fortunes were made and lost.
Madness is what the market does best. It amplifies our emotions, excites our lizard brains, and triggers fight or flight decisions that are often sub-optimal. Madness can be painful, but it can also lead to opportunity. Keeping a cool head amidst market chaos is how some of the best in the business make fortunes for their clients.
The market will always entertain pockets of madness, but over the long term it conforms to the shape of the economy and the direction of economic data. This is why, at Serenity, we always focus on the data. We can trade the market’s irrationality by identifying situations in which investors are falling under the sway of false narratives as opposed to calm, rational analysis.
In the REIT market this means taking an honest look at heavily shorted names that have suddenly ripped higher. Has the value of bankrupt Mall REITs really doubled or tripled over the past two weeks?
It also means taking an honest appraisal of the coronavirus pandemic. With a never-ending cacophony of negative news headlines, it’s easy to be pessimistic about COVID-19. The data, however, tell a different story; one of rapidly declining cases, accelerating vaccinations, and a more rapid timetable for herd immunity than many acknowledge in the media.
So sit back, have a drink, and try not to get worked up over events that are out of your control. Serenity clients have been able to rest easy as our process removes as much emotion as possible, and has even profited from some of the recent short covering mania.
Performance: -0.40% in January
January was an up and down month for the fund which closed on a low note with performance of -0.40% to start the year. A few of our larger positions sold off into the end of the month as volatility in the market rose and negative sentiment increased. The economics of these companies have not changed, however, and in the fund we used this volatility to add to some of our higher conviction bets, such as Boston Properties (BXP), Extended Stay America (STAY), and NexPoint Residential (NXRT).
Boston Properties (BXP) owns one of the highest quality office portfolios in the US. The company has few leases expiring from 2021-2023, a highly leased development pipeline that will begin paying rent over the next two years, a fortress balance sheet, and trades at a 30% discount to consensus NAV (Net asset value). The outlook for offices remains uncertain, but BXP is extremely cheap and well positioned within the office market. Any good news on the return-to-work front should send BXP shares meaningfully higher.
Extended Stay America (STAY) is a US focused lodging company with an outsized exposure to leisure travel. STAY trades at a 10.5x 2022 EBITDA multiple versus peers at 15.7x. STAY had already recovered to 2019 occupancy levels by August of last year, and is set to benefit from more domestically focused travel over the next 6-12 months. As more US citizens chose to vacation domestically, STAY is poised to drive occupancy and ADR higher in 2021.
NexPoint Residential (NXRT) is a sunbelt focused multi-family company specializing in value-add projects. NXRT is small enough that it can target higher IRR projects than peers and should exhibit sector leading earnings growth over the next 5 years. Prior to the pandemic NXRT was the fastest growing Apartment REIT and it currently trades at a deep discount (15.4x 2022 AFFO vs 20.9x for the sector) to other Apartment REITs. As growth resumes and NOI inflects positively, NXRT should be able to close the valuation gap and deliver compelling total returns.
In the rest of the portfolio we remain overweight value REITs, cyclical REITs, and REITs that will benefit from re-opening of the economy. As we will discuss later, we are still of the view that it is only a matter of time before economic momentum begins to accelerate and meaningfully enhance the cash flow of many beaten down REITs. In fact, the recent violent squeeze in many heavily shorted companies in part springs from an economic outlook that continues to improve.
SURVIVING A SHORT SQUEEZE: RESPECT THE CYCLE
The big story in the stock market in January was not a positive one for many hedge funds. Highly shorted companies shot violently higher in the second half of the month, inflicting significant losses in many, highly regarded, hedge fund portfolios. Some funds lost as much as 30-50% during the month, and many quietly closed as sponsors pulled their funding. While Gamestop (GME) was the key culprit in this recent mania, even the REIT market saw its effects, with highly shorted Mall REITs and select others exploding higher over the last two weeks.
From January 1st to Feb 1st PennREIT (PEI) was up +142%, Washington Prime (WPG) was up +95%, Macerich (MAC) was up +36%, Iron Mountain (IRM) was up +13%, and Tanger Outlets (SKT) was up +44%. If you are keeping score that is one bankrupt mall company, one B-mall company, one highly levered A-mall company, a paper storage company, and an outlet mall retailer. For the sake of perspective, this basket has returned on average -19% on an annualized basis since the end of 2018. Even after the recent rally, that’s an excellent short book over the last two years.
Now here is where the rubber meets the road. Were these companies good shorts two years ago? Yes. Have their businesses meaningfully improved since then? No. So were they good shorts in early January? NO!
The key here is that the fundamentals of a company are only ONE component of what moves its stock price. Style factors and macro-economic events also play a large role in the movement of REITs and other equities. This is what many fundamental investors continue to miss, and why at Serenity, we continue to get these large moves correct. We respect the macro environment, and we control our exposure to style factors.
Coming into January, our outlook was meaningfully bullish. Evidence continues to accumulate that the bottom of the economic cycle was reached in March or April of last year. That means that over the next few years, economic data is likely to slowly improve as the economy heals. In this type of environment, it does not pay to be overly bearish, especially in extremely cheap, highly shorted value names such as PEI, MAC, WPG, and SKT. We are extremely aware of how bad fundamentals are at these companies, but we have intentionally excluded them from our short book over the past few months for exactly the reasons detailed above. We did not believe it made sense to continue shorting beaten-down companies as economic data accelerated.
The result of this framework is that we had very few shorts that did not go our way in January, and 0 positions that exploded higher and caused us meaningful pain. In fact, we were able to fade the incredible move-in MAC, shorting a small amount of it at $22.25 and reaping a 36% gain in just over 3 days. As we always say, timing matters.
The big takeaway here is that a robust investing process takes into account as many potential return drivers as possible when making decisions on individual stocks. Not only how well the company is doing fundamentally, but also how it fits into the broader macro-economic landscape, and what style factors may influence its movement. Measuring and mapping these data are important aspects of risk management which ensure you don’t blow yourself up. This month, not blowing up was a big win.
CORONAVIRUS: THE UNTOLD STORY OF APPROACHING HERD IMMUNITY
Staying with our theme of being macro-aware, we have noticed an increasing number of bearish headlines both in the general news media and the financial press. Most center around the impending threat of new coronavirus variants, the slow roll-out of the vaccine, or elevated equity multiples. In our view, all three of these narratives miss the mark, and investors that are outright negative run the risk of further pain in their portfolios.
As always, however, how we feel about the current narrative makes little difference. The data, however, do make a difference. So, what do recent data points actually tell us about how the pandemic is evolving?
Let’s start with new cases in the US. The chart to the right illustrates a phenomenon that has been mostly absent from front page news headlines. Namely, that the 7-day moving average of new cases in the US has fallen from 254,000 on January 11th, to 150,000 on January 31st. That’s a 38% drop in the span of less than a month. New cases are now back to November levels and falling rapidly.
Not only that, new cases in some of the hardest-hit states have fallen and remained low for months now. Both North Dakota and Iowa have confirmed positive tests in over 10% of the state’s populations and have seen new case counts fall meaningfully from their Nov/Dec 2020 highs and remain low without lockdowns or other aggressive restrictions.
While North Dakota and Iowa are not great representations of the broader US from a population density standpoint, they serve as good examples of what we might expect as broader swaths of the population become immune via vaccination.
With case counts demonstrably on the decline the question then becomes what could bolster or reverse this trend? We all know the answers to that question. Vaccines and virus mutations.
While the rollout of vaccines has been much maligned, that has to do as much with unrealistic expectations as it does with poor planning. These types of logistical challenges take time…just remember how difficult it was to get a COVID test in June or July of 2020. Now it takes about 30 minutes, and the country has performed over 312 million tests, or one each for 94% of the US population.
Vaccines are charting a similar but much quicker path higher…somewhat slow to start but with rapid acceleration. Over the last 7 days, the US has averaged 1.3m vaccinations per day, up from just over 1m the prior week. If we can reach a pace of 1.7m vaccines per day by March 1st, 100% of the population could theoretically achieve immunity by early August of this year. That doesn’t sound so bad does it?
And there are reasons to believe herd immunity will be achieved well in advance of that August estimate. The US so far has about 26 million confirmed cases of COVID-19. That’s about 8% of the population.
We have also vaccinated 25 million people at least once, so add another 8% to get to a total of 16% of the population on their way to confirmed immunity (we realize you need two doses and assume those getting the first will follow up and get the second a month later).
Now let’s add in asymptomatic cases.
Everyone knows that asymptomatic cases of COVID-19 are extremely common, but nobody knows exactly how common. There is also debate as to how much immunity you acquire with an asymptomatic case. For both of these reasons, commentators tend to ignore this number because it’s so hard to know with accuracy. But what if asymptomatic carriers do become immune? This would mean the number of people in the US with immunity is much higher than the 16% that has been confirmed. But how much higher? This is where we have to make some educated guesses.
Based on serology data collected by the CDC (blood tests collected and tested for COVID antibodies), in many states dating back as far as April/May, COVID antibodies were found in 2-10x more blood samples than suggested by confirmed cases. In Illinois for example in mid-November, the number of estimated infections was over 2 million based on seroprevalence estimates (again these are from the CDC’s website). At that time the number of reported cases was 726,109. That’s almost 3x as many cases as positive tests.
There was also a recent study of pregnant women checking into hospitals that showed as many as 55% tested positive for COVID-19 but showed no symptoms. Could there be twice as many cases as we think of COVID-19 in the US? Let’s make that assumption and add another 8% of the population that is currently immune to COVID-19 but showed no symptoms. That gets us to 24% of the population as currently immune or on the path there.
That’s still a good distance away from herd immunity, but remember, vaccinations are accelerating. At the current rate, we are vaccinating about 1.1 million NEW people each day, so roughly 33 million people per month. Keeping with round numbers that is almost exactly 10% of the population being vaccinated each month, meaning in roughly four months (by the end of May) 64% of the population could theoretically be immune. That is herd immunity or at least very close (depending on how you define it).
Now assume that by March we can double the pace of vaccinations to roughly 60 million per month. That would suggest that in March and April alone, we could vaccinate 120 million people, or over 1/3 of the population. That makes herd immunity by May less of a possibility and more of a virtual certainty.
Now for the final variable and the medias favorite headline…new COVID variants. It is certainly concerning that new variants of the coronavirus in the UK, South Africa, and Brazil seem to be more contagious, and possibly less impacted by vaccine immunity. There is little data, however, in our view, to suggest that these variants are somehow a game changer. Just look at cases in the UK and South Africa. They are falling precipitously in both countries.
While lockdowns certainly explain much of these recent drops, shouldn’t a massively more infectious form of the virus at least be distinguishable in the new case data of its native countries? Add in the fact early returns indicate most vaccines still confer immunity to the majority of these variants, and there seems to be a lot of alarm without a lot of data behind it.
In our view the bottom line is this. The US is vaccinating its population rapidly while cases fall equally rapidly. Not only are trends going in the right direction, but they are set to accelerate as pharmacies open for vaccinations and more of the general population becomes eligible. Add in the potential approval of two more vaccines by the end of the month, and in our view, we see a turnaround for many REITs and value stocks driven by a rapid return to work and unleashed pent up demand into the second half of 2021.
CYRUSONE (CONE): A TURN-AROUND ABOUT TO GAIN MOMENTUM
This brings us to CyrusOne (CONE). Over the past few years, it has paid to be skeptical of CONE. The company fired their CEO, took over 6 months to find a new one, saw turnover in the sales department, and, not surprisingly, saw leasing momentum drop to un-inspiring levels. In spite of this, CONE has still outperformed the REIT index by over 22% on an annualized basis since we recommended it on Dec. 19th, 2019.
The bull case for CONE, however, is now stronger than ever. Demand for data center space has only been helped by the pandemic, the stock is extremely cheap relative to peers, and their new CEO has an excellent track record of successfully orchestrating REIT turn arounds. This simple trifecta of factors makes CONE one of our best ideas for 2021.
The continued growth in data demand should be a surprise to no one at this point. Research and Markets expects global cloud computing to grow at a 17.5% CAGR until 2025, a blistering growth rate for a $371 billion market. Per an August 2020 report: “Digital business transformation has entered a more challenging and urgency-driven phase due to the COVID-19 pandemic.” The proliferation of Zoom meetings, remote work, more data intensive applications, and massive flexibility make the cloud (off premises servers) a no-brainer solution for data storage and computing needs for every single company. This growth in cloud spending translates directly into demand for data center space, of which CyrusOne is a top tier provider. Add in the fact that Europe is years behind the US in terms of cloud adoption (has a longer runway and a steeper curve), and CONE is well positioned to capture continued cloud growth around the world with its large US and European data center portfolio.
The problem recently, however, has been CONE’s lack of ability to capitalize on this demand in a way that drives its earnings higher at the same rate as its peers. As earnings growth at CONE has lagged peers such as Equinix (EQIX), investors have driven the two companies’ valuations apart, with CONE trading at a meaningful discount to EQIX across almost every valuation measure. The table below illustrates how wide the gap between the two companies has become.
This brings us to the catalyst of this story and the reason we think CONE is set to start closing the gap between it and other Data Center REITs. As we mentioned above, CONE has seen significant turnover in its management suite over the last year, causing it to lose leasing momentum and fall behind competitors. Instead of re-hashing the entire series of events, it’s more instructive to focus on the present, and current direction of the company under the leadership of it’s new CEO, Bruce Duncan.
Those with professional experience in the REIT industry know Bruce Duncan. He successfully orchestrated turnarounds at Equity Residential (EQR – Sam Zell’s Apartment REIT), and more recently First Industrial (FR), which he took from a $2 stock in 2009, to a $28 stock when he left the company in 2016. He has a reputation as a pragmatist and is known to have the view that if you can’t get the stock moving, you sell the company.
Now this is an important note because REIT management teams are historically reticent to take their companies private, even when it would be the best move for shareholders. REIT CEO’s get paid very well to manage their companies, many of them enjoy being the face of a public company, and many are mildly delusional about how high their stock prices could possibly go. For these reasons many REIT investors appreciate Bruce’s attitude and acknowledgement that taking the company private at some point may be the best outcome for investors.
In lieu of a takeout, Bruce has made it clear that his goal is to drive leasing and drive earnings growth at CONE, which should help the company to close its valuation gap and drive the stock price higher. He has already communicated a willingness to slightly lower pricing in order to drive leasing volume, targeting 8-10% yields for hyperscale deals, which can then be levered into mid-teens returns. Getting back to high single digit or low double-digit growth for the company would mean meaningful revisions higher in sell-side estimates and a resumption of NAV growth which has been negligible since 2018.
For a bit of context, consensus estimates for 2021 EBITDA are currently $586m for CONE. This represents growth of 8.9% over 2020. If better execution can push this estimate only 5% higher, and investors are willing to pay a 2 turn higher multiple for CONE by years end, the stock price should increase a tidy 15%. That would still assume 2021 EBITDA growth below CONE’s long-term average.
In the end, CONE owns a high-quality international data center portfolio that is poised to benefit from continued growth in cloud computing. It trades at a meaningful discount to peers and has a new management team firmly committed to driving leasing, increasing the stock price, or selling the company. The story is straightforward, and we will find out in coming quarters if the new management team is able to deliver on their goals. In the meantime, we will own the stock, monitoring the fundamentals and risk managing our position.
HEDGE FUNDS BEWARE: DO NOT FIGHT THE CYCLE
2021 has certainly started out with a bang, from political unrest to stock market madness. The populace has cabin fever, and investors are nervous. The path back to normalcy seems far away and indistinct, but it may be closer than we think. New economic and earnings cycles are just begging, and for many companies, the path to significantly higher cash flows begins here and stretches out for years.
A key lesson from the past month is not to fight the tide of economic growth. Even the most backward and highly levered companies can find success in a rapidly accelerating economy. Be careful when evaluating narratives, control your emotions, and let data be your guide.
At Serenity, we will continue to embrace the cycle, monitor REIT style factors, keep tabs on company fundamentals, and concentrate our bets in high quality REIT portfolios that will benefit from the coming re-normalization of the economy. Our annualized returns over the last 2 years are in excess of 25% net of fees, and we plan on keeping that train rolling. Like Leonidas leading the fearless 300, we are trained and prepared for the coming market onslaught.
Spartans, prepare for glory,
Martin D Kollmorgen, CFA
CEO and Chief Investment Officer
Serenity Alternative Investments
Office: (630) 730-5745
**All charts generated using data from Bloomberg LP, S&P Global, and Serenity Alternative Investments
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