Insights

Investment perspectives: Defining risk

5 October 2016

Investment perspectives: Defining risk

Thinking about risk

For many investors, risk is defined by the volatility of returns (movements in share prices). The higher the volatility the greater the risk. In that context, we found the following chart of great interest. 

Source: NAREIT, Quay Global Investors

The chart above depicts the long run risk-return dynamics of US REITs and Infrastructure. The bottom right is good (low risk, high return). Interestingly, Quay’s US portfolio is heavily skewed to these sectors (Health, Manufactured homes, storage etc.).

While this chart supports the current position of the Fund, we gain no comfort from it. This is because we do not view risk through the prism of volatility. We take a much more fundamental approach. 

Before we define risk, we must first define our investment objective. If we were to measure our investment objective relative to an index, risk is defined as variances to the index. However, we define our investment objective as foregoing consumption today for greater future consumption. Extending from this, we view risk as any situation where this isn’t likely to occur – where it’s not likely an investor will receive greater purchasing power in the future. So at Quay, risk is defined as the real loss of purchasing power over time.

How does Quay manage its risk? The answer lies in our investment process. We spend most of our time seeking the best ‘after inflation and fees’ investment propositions, underpinned by six criteria:

Reliable long-term cash flows. Quay focuses on rent-based asset returns in developed markets with stabilised assets. We prefer to avoid developers and significant exposure to emerging economies. Development earnings tend to be pro-cyclical and capital intensive. Earnings from developing economies are subject to greater political risk, as property rights may not be as established or clear as they are in developed economies. By avoiding business models that rely on development returns, we can construct a portfolio of securities with greater certainly in cash flow. We fundamentally believe the greater certainty in cash flow, the lower the risk.

Robust balance sheets. In assessing a company’s balance sheet, we look for capacity (for example, debt to EBITDA, debt to enterprise value or available liquidity) and assess credit risk by looking at interest cover, debt duration and performance against debt covenants. Low leverage is not always low risk; just as high leverage is not always high risk. As always, context is important. Assessing balance sheets allows us to mitigate credit risk, but also earnings risk by assessing the company’s capacity to grow cash flows over time.

Strong management teams. We believe listed real estate returns are highly influenced by the ‘investment process’ of the investee. It is critical to focus on the opportunity set and management approach to generating returns. We like management teams that are sector specialists, with a robust and well defined investment process as well as a track record of value creation for shareholders and adhere to sound corporate governance principles.

Simple business models. We believe predictable long-term cash flow generation comes from relatively simple business models. They’re often focussed on one sector, in a limited geography and tend to avoid complexity.  In our view, a simple business model means ’less can go wrong’.

Investment with reference to replacement cost Quay conducts analysis of various real estate sectors, assessing replacement cost, the amount of stay-in-business capex required to operate in the sector, supply levels and sector performance against ‘real’ interest rates. Over time, we believe a portfolio of securities priced at or below the cost to replace (where relevant) that generates high free cash flow is the most effective way to preserve capital, and hence minimise the risk of permanent capital loss.

Favourable secular themes and demographic tailwinds. By assessing demographic and secular themes, such as the rise of e-commerce, generation rent and the ageing population, we are not only looking for earnings tailwinds but head winds and risks to underlying cash flows and valuation. For example, we view the risk for demand for aged care facilities and hospitals as very low over time. Conversely, tenant demand for shopping centres is less clear.

By concentrating on the quality of the cash flow and the price we pay for it, with reference to replacement cost, expected real returns and ‘real’ interest rates, we focus on achieving real total returns rather than beating an index. We believe that over time this process will provide superior returns without a commensurate increase in risk. As with many other investment concepts, Warren Buffett often offers the best summary: risk comes from not knowing what you’re doing”.

Investment process at work

In the chart prior, it comes as no surprise that over the long term the sectors we define as ‘low risk’ (circled in red) tend to have the historic data to support our approach.

While our investment process led us to focus on the health care, self-storage, manufactured housing and apartment sectors, we couldn’t help but notice these sectors have offered the highest and most consistent returns over 20 and 5 years (below) against other sectors. We believe this is testament to their solid track record of cash flow generation, with simple business models, enjoying the benefit of secular themes and demographic tailwinds.

Source: NAREIT, Quay Global Investors

We see evidence of this in the chart below, which shows same-store net operating income (SS NOI) growth over the past 20 years for select sectors. It is apparent that top-line income growth is more consistent and less cyclical in some of our preferred real estate sectors. Cyclicality can also represent opportunity at the right time, however requires a sharper eye on risk. 

Source: NAREIT, Quay Global Investors

Investment Implications

While some investors view risk as volatility, the implicit assumption behind this view is that markets are efficient. As active investors, we fundamentally believe markets are inefficient. This doesn’t mean we don’t see risk as volatility, but it does mean that through a comprehensive investment process, focussing on fairly valued investments with sustainable and growing cash flows, we believe we are able to reduce the risk of permanent capital loss over time.

 

Disclaimer

The content contained in this article represents the opinions of the authors. The commentary in this article in no way constitutes a solicitation of business or investment advice. It is intended solely as an avenue for the authors to express their personal views on investing and for the entertainment of the reader. In particular this newsletter is not directed for investment purposes at US persons.

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