Bt Investments Blog

Over the course of 2009, the APxJ analyst team published
612 Research Tactical Ideas (RTI) targeting short-term
tactical opportunities. The RTIs allow analysts to express their views on the likely direction of near-term stock price movements, complementing their long-term fundamental view
on the stock. Analysts can express this view in absolute or relative terms over a stated time-period that ranges from 15 to 60 days. In a straightforward publishing template, they also
provide a brief rationale and indicate their level of conviction on the idea on a three-point scale.

We find that in aggregate the 612 RTIs generated positive results for 2009. Using a potentially conservative metric of gross capital allocated to active RTIs, we compute that over the course of 2009, the cumulative Return on Average Capital was 14.7% and the cumulative Return on Maximum (Peak) Capital was 8.0%. The results suggest that the RTIs complement our core, risk-reward-based fundamental research product in a way that can deliver value-added for
our clients.

We track RTI activity and performance carefully to ensure our product can deliver value-added (α!) for our clients. Measuring RTI activity for our coverage universe is easy: we simply track how many active ideas are outstanding on a daily basis. Exhibit 1 shows that, after a slow start in 2009, our analysts kept up a steady flow of RTI publications throughout 2009, with a surge late in the year before the holiday season.This regular maintained level of activity is necessary for the XTI product to be relevant for α-capture clients.

Profit/loss (P&L): Our metric of choice to summarize RTI performance. We base the P&L of a single RTI on two components:

Return measure: We measure absolute total returns or returns relative to a benchmark return over the relevant time horizon, depending on the case. Our return calculation also takes into account trading costs and other trading constraints. (For further details, see full report.)

2) Nominal investment in the RTI: We assign a nominal US$- denominated investment to each RTI based on the conviction of the idea: we assign US$5mn, US$4mn, and US$3mn to ideas of 80%+, 70%-80%, and 60%-70% probabilityconviction, respectively. In our calculations, we limit the nominal notional investment for each idea to a maximum of 20% of trading volume (in US$) on the day of execution of the RTI if the former exceeds the latter. If an idea cannot be executed (e.g., short-sale restrictions) when published, we set the notional investment of rejected ideas to zero. Relative ideas lead to offsetting long and short nominal exposure, while absolute RTIs generate exposure in only one direction. We aggregate idea-level P&Ls and nominal investments
to get the results for the region over the course of 2009.

Exhibit 2 shows that while we started the year in the black, the team incurred losses in March and April that left cumulative P&L to be negative by the end of March. However, the monthly P&Ls rebounded strongly from May onwards resulting in a cumulative P&L of $23.3m for the year. Overall, monthly P&L was positive in 10 out of 12 months.

READ FULL REPORT HERE

02/02/10 Jacobus, Pennsylvania – The commercial real estate crisis may be the most anticipated crisis in history. But just because it’s widely anticipated doesn’t mean that the crisis won’t be destructive for REIT shares. Since most REITs are richly valued, the slow-moving commercial real estate crisis will ensure that future returns disappoint.

Consider the valuation of REITs versus the S&P 500, which itself is overvalued. Despite being 25% below its late 2007 peak, the US stock market – measured by the S&P 500 index – is very expensive. The “Shiller P/E ratio,” developed by Yale professor Robert Shiller, measures the S&P 500 against the average S&P 500 earnings over the previous 10 years, adjusted for inflation. It’s a much more robust measure of valuation, considering the fluctuation of corporate earnings, and the fact that after bubbles, much of the earnings booked during the boom are written off during the bust. Consider that the earnings booked by Citigroup and other big banks near the peak of the bubble were largely written off during the bust. Therefore, a 10-year average of earnings is a better indicator of true earnings.

The Shiller P/E ratio for the S&P 500 Index is now 21 – up dramatically from 13 at the March 2009 lows. This 21 P/E is higher than at almost any point in stock market history, outside of the late 1920s bubble, the late 1990s bubble, and the market peak in 2007. The S&P 500 is overvalued based on the Shiller P/E, but corporate earnings are supposedly going to soar in 2010, right? Well, even if you believe the optimistic 2010 estimates, the market is still more than fully valued on that metric.

Ditto REITs.

Commercial real estate – and the REITs that hold commercial properties – began to deflate rapidly in late 2008. But the Fed stepped in with bailout funds and easy money to halt the deflation…and even pumped the bubble back up a bit. The nearby chart shows the results of the Fed’s handwork. REITs of all shapes and sizes more than doubled off the stock market lows of last March, while the Bloomberg Hotel REIT Index more than tripled. (We’ll come back to this chart a little later).

This rally has the look and feel of a dead-cat bounce, which means that it provides an attractive short-selling entry point.

REITs soared as the bubble inflated from 2000-2007, then crashed when the bubble popped in 2008 and early 2009, and then launched a dead cat bounce when the Fed flooded the system in mid-2009 with massive injections of liquidity and cheap credit. Now REITs are priced at bubble valuations – valuations that bear little resemblance to economic reality.

This bounce has postponed a healthy purge of assets in which old capital invested by foolish speculators during the bubble would have been wiped out – clearing the way for new owners to assume title to real estate at reasonable prices. When central banks prop up deflating bubbles with super-easy bailout cash, the bubble investors don’t liquidate their overly inflated assets. They hang on and hope for a turnaround.

But bubbles always deflate…always. Government intervention merely muffles the hissing sound for a while. This story played out in the Japanese real estate bubble that peaked in 1990, and it’s happening with the US commercial real estate bubble that peaked in 2007. Capital becomes trapped in a dead asset class, thereby stretching the bubble’s resolution out over decades.

Toward the end of 2009, it became clear that “extend and pretend” had become the official policy at most banks that hold commercial mortgages. We won’t see a cleansing flush of hundreds of billions in underwater properties changing hands to new owners. Instead, properties will be dribbled out of the foreclosure pipeline at a slow pace. This measured pace of foreclosures will add to the chronic glut of property that will be quickly listed for sale into any bounce in demand.

Some of the best short-selling opportunities in the REIT sector may be in the hotel REIT sub-sector.

It’s not a stretch to expect the hotel business will be ugly for a long time. Corporate and leisure travel is in the midst of a depression. And leveraged hotel owners built or acquired too many hotels near the peak of the commercial real estate bubble.

Now many hotel owners are desperate to generate cash in order to pay down debt and retain titles to properties. Some are slashing nightly room rates below break-even levels. You know from the growth of Internet hotel booking services just how much more competitive and transparent hotel pricing has become over the past decade. Unless competitors are willing to match the pricing of the most desperate hotel owners, healthier competitors will suffer lower occupancy.

Some levered hotel owners, like Sunstone Hotel Investors, are abandoning their equity in some properties to salvage others. In the fourth quarter of 2009, Sunstone defaulted on several nonrecourse mortgages held against 13 of its properties and turned the title over to its lenders. Sunstone calls this a “deed-back,” but it’s really a strategic default.

Sunstone’s lenders will probably keep and operate the hotels, rather than dump them at a distressed price. The behavior of Sunstone and its lenders shows how many hotel owners and lenders are putting off the necessary liquidation of underwater properties with bloated cost structures. The industry still needs to make more progress on downsizing, slashing operating costs, shrinking mortgage sizes, and lowering room rates to match demand. Until it does, the industry’s returns on capital will not consistently exceed its cost of capital.

Hotel REITs are highly sensitive to perceptions about the near-term health of the hotel business. Trends in occupancy and room rates shape perceptions about earnings. Hotel REITs own portfolios of hotels and outsource the management to companies like Marriott for a fee.

Because of the relatively fixed costs of paying management companies a fee for operating hotels, Hotel REITs operate with high operating leverage: A 20–30% decline in revenues can translate into a 50–75% decline in operating income. Also, unlike offices or retail REITs with sticky long-term leases, the cash flow for hotel REITs adjusts quickly to changing conditions on a day-by-day basis.

Over the past nine months, hotel REITs have soared on the perception that corporate and leisure travel will rebound strongly in 2010 and 2011. Analysts have forecast a sharp rebound in earnings.

But I’m not buying it. In fact, I’m selling it.

Regards,

Dan Amoss
for The Daily Reckoning