Consistency In The Chaos

Consistency In The Chaos

In writing this article, I find myself going back to 1993, when a movie called Jurassic Park debuted in theaters.

At the time, it was loved and lauded not just for its drama, dialogue (“clever girl.”), and technological displays. Certain characters also stood out intensely, such as Dr. Ian Malcolm, a meme-ready mathematician obsessed with what’s called Chaos Theory.

According to Investopedia:

“Chaos theory is a complicated and disputed mathematical theory that seeks to explain the effect of seemingly insignificant factors. Chaos theory is considered by some to explain chaotic or random occurrences, and the theory is often applied to financial markets. Chaotic systems are predictable for a while and then appear to become random.”

The article goes on to state its own opinion this way:

“There are two common fallacies about stock markets. One is based on classical economic theory and claims that markets are… (completely) unpredictable. The other theory is that markets are, at some level, predictable. Otherwise, how do big trading houses and investors consistently make profits?

“The truth is that markets are complex and chaotic systems, and their behavior has both systemic and random components. Stock market forecasts can be precise only to a certain extent.”

As should be expected, there are die-hard fans and detractors alike when it comes to Chaos Theory – no doubt some of whom found their passion directly from Jurassic Park, whether the book or the movie.

I guess why not?


Someone Always Could Jump Out of a Moving Vehicle

Here’s another definition of Chaos Theory to consider, this one found on based on Jurassic Park, the novel:

“Chaos theory says two things. First, that complex systems like weather have an underlying order. Second, reverse of that – that simple systems can produce complex behavior. For example, pool balls. You hit a pool ball, and it starts to (careen) off the sides of the table. In theory, that’s a fairly simple system, almost a Newtonian system.

“Since you know the force imparted to the ball and the mass of the ball, and you can calculate the angles at which it will strike the walls, you can predict the future behavior of the ball. In theory, you could predict the behavior of the ball far into the future as it keeps bouncing from side to side. You could predict where it will end up three hours from now, in theory.

“But in fact, it turns out you can’t predict more than a few seconds into the future. Because almost immediately, very small effects – imperfections in the surface of the ball, tiny indentations in the wood of the table – start to make a difference. And it doesn’t take long before they overpower your careful calculations. So it turns out that this simple system of a pool ball on a table has unpredictable behavior.”

Or, to quote a conversation from the movie:

Dr. Ian Malcolm: There. Look at this. See? See? I’m right again. Nobody could’ve predicted that Dr. Grant would suddenly jump out of a moving vehicle.

Dr. Ellie Sattler: Alan? Alan! (Jumps out of the vehicle.)

Dr. Ian Malcolm: There’s another example. See, here I’m now sitting by myself, uh, er, talking to myself. That’s – that’s chaos theory.

In short, you just never know what’s going to happen next.


A Long-Term Solution to Chaos

I understand Chaos Theory. I even agree with it somewhat – as any realist or competent, observant adult who’s experienced 2020 has to. As noted in “Always, and I Mean Always, Protect Your Hard-Earned Principal at All Costs,” anything really can happen. At any time:

“Of course, we can’t completely protect against everything that could come our way. For instance, I have no recommendations for keeping portfolios safe against black holes, giant meteors, zombie apocalypses, (or) lizard people.

“If the first opens up to swallow us whole… the second decimates the Earth… the world turns into a flesh-eating playground… or aliens among us decide to change their secretive ways and come right out to change the order of things…

“You’re on your own.

“Otherwise, I’ve got some great advice for you. And it doesn’t boil down to ‘better safe than sorry.’”

Take that pool table example. You actually can do an impressive job of predicting how your shot is going to go. It simply depends on:

  1. How much you practice.
  2. How well you maintain your equipment.

The more you practice, the more you understand the possibilities at play. And the more you keep your pool parts and pieces in tip-top shape, the more you control what goes where and when.

Somebody might still bump you, it’s true. A minor (or major) earthquake might still send your shot wide. Or you might get one of those obnoxious pinpoint itches at the exact wrong moment.

But your long-term game is going to be impressive, nonetheless.

In the same way, when you study the markets long enough, testing out what works and what doesn’t, and keeping your positions safe and small, you’re almost certainly going to come out ahead over time.

Anchors and Buoys

Benjamin Graham once said that “earnings are the principal factor driving stock prices.” And it’s the dependability of dividends that drive total returns.

Personally, I’ve found the most important way to generate superior returns is by purchasing shares that generate consistent profit margins over time.

When you think about it, real estate investment trust returns are much easier to forecast. This makes sense when their growth is predicated on contractual lease contracts.

I can’t tell you how many lattes Starbucks will sell in 2021. It’s much easier to predict that Realty Income (O) will generate earnings growth of around $3.47 per share in 2021.

(See FAST Graph forecasting tool below:)

Source: FAST Graphs

Now, keep in mind that certain REIT property categories are worse off. For instance, with social distancing, the lodging sector is almost impossible to forecast. So we’re being extremely cautious with this sector.

But others are much more reliable. Take our Durable Income Portfolio, which has more than 60% invested in the most durable divided payers. Here’s its current weighting:

  • Net Lease (19.9%)
  • Healthcare (18.6%)
  • Data Centers (11.4%)
  • Industrial (4.2%)
  • Cell Tower (3.1%)
  • Gaming (2.9%).

Source: Sharesight

Its larger strategy derives from the “anchor and buoy” concept.

Back when I built shopping centers, I always would design them with an anchor in mind companies like Walmart, PetSmart, Bi-Lo (formerly Ahold credit), and Dollar Tree.

The anchor store leases were generally flat (20-year term). The smaller shop leases were generally shorter term (five years) with more frequent rent growth. So the former would provide predictable income, and the latter served as a buoy to provide yield enhancement.

Similarly, the Durable Income Portfolio is designed to provide both stable income and yield enhancement. As you can see below, it has 39.9% exposure to the “buoy” holdings:

Source: Sharesight

How We’re Doing So Far

Over the last 120 days, I’ve heard from many readers and investors. One of the most frequent questions is how iREIT on Alpha’s portfolios have performed during COVID-19.

After all, back in December, I was predicting REITs would generate returns of 10%-12% in 2020.

As you can see below, Vanguard Real Estate ETF (VNQ) shares have declined by 15% year-to-date. And its market cap-weighted strategy contains stocks that are 67% “buoy-focused,” including through retail picks (8.8%) and offices (8.2%).

Yahoo Finance

Similar to most ETFs, you’re essentially getting the good, bad, and ugly. And while VNQ’s top six positions are durable anchors representing 30.6% of the holdings… the “bad and ugly” offset their strong performance to provide poor returns.

Alternatively, the so-called “anchor and buoy” strategy has returned -2.84% year-to-date (including dividends).

Source: Sharesight

Our top five performers so far this year are:

  • Hannon Armstrong (HASI) 66.2%
  • Essential Properties (EPRT) 42.9%
  • Ladder Capital (LADR) 31.4%
  • CyrusOne (CONE) 28.4%
  • Digital Realty (DLR) 22.6%.

Sure, we have some not-so-good performers too, such as:

  • Federal Realty (FRT) -37.4%
  • Brixmor Property (BRX) -24.2%
  • Kimco Realty (KIM) -42.5%
  • Tanger Outlets (SKT) -50.2%
  • Simon Property (SPG) -55.8%.

However, they’re all shopping center or mall REITs. Knowing the risk there, we’ve limited our exposure to under 5%. Total.

There was no way we could have predicted the current chaos we’re witnessing today. But we were able to mitigate risk by maintaining tactical diversification.

And we have the same profit-saving mindset going forward.

The Silver Lining…

We’re now just over halfway through 2020. And while I grant you that -2.8% total returns are disappointing – especially when compared with my 2020 target of 10%-12% – I’m a long-term investor focused on principal preservation and sustainable income.

Because I’ve anchored my REIT portfolio with durable income, I’m satisfied that:

  1. My nest egg is safe
  2. I should see long-term price appreciation.

Over the last few months, I’ve increased exposure in many high-quality REITs with enhanced price appreciation on my mind, while always focusing on reliable dividends. Of course.

As illustrated below, the primary anchors for the Durable Income Portfolio are:

  • Realty Income (7.3% exposure)
  • CyrusOne (6.2% exposure)
  • Essential Properties (5.9% exposure)
  • Digital Realty (5.3% exposure)
  • Crown Castle (3.1% exposure).

Together, they make up 27.8% of this portfolio.

Source: iREIT

As referenced above, we consider earnings growth critical. Without consistent funds from operations (FFO) growth, there’s no steady dividend growth.

And without dividend growth, total returns aren’t sustainable over the long term.

Source: iREIT

I do recognize that payout ratios for Realty Income and Essential Properties (EPRT) are elevated now. But we’re comfortable holding them nonetheless based on their liquidity and overall risk profiles.

Source: iREIT

In fact, we bought more shares in O on April 7 and EPRT on April 24.

Source: Yahoo Finance

Clearly then, we’re confident enough in our current choices.

In Closing…

Our REIT strategy is summed up in Jurassic Park-style “survival of the fittest.” We carefully analyze every potential pick, always asking ourselves these questions before hitting the buy button:

  • How profitable is the REIT by itself and measured against its peers?
  • How will it grow earnings over the next 1-3 and five years?
  • How does it compare financially (with a careful examination of liquidity during COVID-19)?
  • How safe is its dividend, and can it grow its dividend in 2021 and beyond?
  • Is management aligned (stock buybacks, insider ownership, etc.)?
  • Is there a quantifiable margin of safety that exists (am I buying earnings cheap enough)?

I’ll be the first to admit that I’ve never been through a global pandemic. The current market chaos is all-new terrain for the author of The Intelligent REIT Investor.

Even so… +12.1% annualized returns since 2013 (as illustrated below) is not so bad after all

Source: Sharesight

And I do know that getting in on the bottom of a market selloff is much better than getting in at the top. So while many investors have run for the hills, we’re maintaining a steady hand.

We won’t miss out on the opportunity of a lifetime.

We can’t predict when theaters will recover or when malls will become mainstream again. But we can forecast with reasonable certainty when certain REITs will grow their dividends.

That’s why I’ve been able to sleep well at night regardless.

I can’t predict the future. But I can navigate REIT-dom with a high degree of certainty that my “anchor and buoy” model will help me navigate most any cycle.

That’s what I call consistency in the chaos!


Author’s 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.

Disclosure: I am/we are long CONE, DLR, EPRT, FRT, HASI, KIM, LADR, O, SKT, SPG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Originally published on Seeking Alpha

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