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To Make Big Profits, You Must Avoid Big Losses

July 12, 2014 | About:

I hope you will indulge me by taking the time to read this 4-article series on overvalued businesses and how the “professionals” recommend them and consider if these are really the type of current valuations to projected future prospects that present investment opportunities that you truly believe to be compelling. If your answer to the question is no, then you should really be asking yourself why most people seem to believe that the small, individual investors can’t beat the market? I think it is because the “professionals” spend a great deal of time and money trying to convince us that we can’t so we will continue to pay them to do it for us.

I know the vast majority of people who read articles on investment sites are looking for ideas on how to locate their capital. I agree that it is very important to find attractive businesses in which we can safely place our capital; however, to be able to build lasting wealth, we also have to learn how to avoid those assets that are overpriced to the point of being dangerous.

In addition to avoiding these types of overvalued assets through effective due diligence, once we identify them, we can also assess the recommendations of the “professionals” who wish to charge us high fees for managing our investments for us and gain a better understanding as to why we should be able to achieve better performance on our own.

One of my stock screens I run is used to identify stocks that are vastly overvalued at the current time. My purpose for having a stock screen for these results is that it allows me to have a feel as to how many businesses are trading at outrageous valuations. The more businesses there are that are priced excessively, the greater the probability that the overall valuations are becoming stretched.

I Didn’t Analyze The Entire Sector; But, These 4 Are Pretty Pricey.

When I was reviewing my excessive valuation screen results, I was struck by the fact that the commercial real estate REIT sector seemed to produce several names on the list. When this happens, it usually catches my attention. Real Estate Investment Trusts, or REITS, are a type of business structure that pays no corporate tax in exchange for paying out the vast majority of its earnings (usually over 90%) in non-qualified dividends to the shareholders who are then taxed on them at regular tax rates.

REITS have become very popular among income investors and real estate REITS are normally viewed as having a high degree of safety since they own what should be valuable commercial property as the assets of the business. At least, that is what I always thought they were.

The fundamentals of the 4 commercial real estate business I reviewed this morning tell a somewhat different story. Successful investing is not always about learning where we want to invest; just as often, it is about learning where not to invest. That is the case here, as a quick review of the numbers begins to reveal.

The four REITS I reviewed are Kilroy Realty Corp. (KRC), Kimco Realty Corp. (KIM), Eastgroup Properties (EGP) and Federal Realty Investment Trust (FRT).

These Businesses Aren’t Cheap By Any Measure

Value investors, such as myself, seem to always be compulsive about business fundamentals when assessing fair value. The numbers here do not paint a pretty picture in terms of compelling value.

Company Ticker

KRC

KIM

EGP

FRT

Dividend Yield

2.25%

3.88%

3.34%

2.54%

Payout Ratio

1,031%

171%

199%

147.91%

5-Div. Gwth.

-9.61%

-12.64%

0.54%

3.69%

2014 P/E Ratio

22.79

16.69

18.85

25

5-yr. Proj. Gwth.

7.2%

4.3%

6.3%

6.5%

Price/Cash Flow

22.12

15.77

17.92

24.88

Being a value oriented investor, I am always looking for ways to mitigate my risk and increase my upside potential through the acquisition of valuable assets at distressed prices. That is not what I see here. Each of these businesses are trading at huge multiples to their projected earnings growth rates for the next 5 years.

In terms of the prices to free cash flow, KIM and EGP trade at multiples that would be reasonable for world-class businesses that are dominant in a critical industry. But a commercial REIT? I don’t think so. The price to cash flow multiples for KRC and FRT are simply outrageous for these businesses and would be very difficult to justify for any business. Are you really willing to buy a business that will take between 22 and 25 years to earn enough money to pay you back? Not me.

Excellent Management Can Justify High Valuations

Quite often in my life, I have come across people who failed to understand the distinction between price and cost or price and value. A business that appears to be expensive on the surface can, and sometimes does, offer an excellent value due to the existence of exceptional management capable of providing rich rewards to shareholders. How have the management teams of these businesses performed producing high returns for shareholders with the assets they now control? The table below is quite illustrative on this point.

Company Ticker

KRC

KIM

EGP

FRT

Debt/Equity

92%

95%

171%

162%

Interest Coverage

1.37

1.19

1.94

2.42

5-yr. Avg. Return on Equity

5.1%

2.1%

6%

11.1%

5-yr. Avg. Return on Assets

1.9%

1%

2.1%

3.8%

5-yr. Avg. Return on Capital

4.9%

3.1%

-0.7%

7.9%

These are the type of numbers that would cause me to run away (and fast) even from a business with good fundamentals related to the valuations. Here we have a situation where these businesses are not only expensive, they have not performed well in terms of building long-term, intrinsic value for shareholders.

Why Individuals Should Beat The Market

Peter Lynch, who earned his fame at the helm of the Fidelity Magellan Fund, long maintained that individual investors should be able to outperform the market because they were free to do what was best for themselves rather than what was popular in the investment world. He believed that Wall Street analysts were more afraid of being different than they were of being wrong. It makes sense when you think about it. If everyone is wrong together, no one gets fired alone. If you express a different view and are proven wrong, well, you are then wrong and gone.

What do the analysts who cover the high priced stocks of these businesses providing such poor returns think? You might be surprised and their thoughts on these businesses should provide you with adequate cause to question their advice on anything you should do with your money. Of course, you notice that it is advice for YOUR money, not theirs. See if you agree with their views after having reviewed these businesses.

Company Ticker

KRC

KIM

EGP

FRT

Strong Buy

6

6

1

4

Buy

0

0

2

0

Hold

5

8

6

10

Moderate Sell

0

0

0

0

Strong Sell

0

1

2

0

So, out of 51 analysts opinions on these stocks, only three think any of these businesses should be sold and the other 48 think you should hold them in your portfolios or add them if you don’t already own them. On top of that, 17 of these opinions express a strong opinion that your should buy the stock now! How hard is it to believe that an individual investor can’t find better opportunities for the allocation of their investment capital than these four businesses?

And these people have the audacity to tell me I can’t do better than this? As the famed question asks: “Where are the customers’ yachts?” Now we know why they don’t exist.

Final Thoughts And Conclusions

While this should not be construed as a comprehensive evaluation of the commercial REIT sector of the market, if the rest of this sector has performance results and valuations similar to this sample, value investors would appear to be wise to avoid exposure to it. The current bull market in stocks can, and probably will continue to run higher based on the loose monetary policies of governments around the world. As equity prices continue to rise, risk avoidance becomes increasingly important. A big part of avoiding big losses is avoiding vastly over valued assets.

This type of analysis work is certainly not as entertaining to read as those articles that tout enormous profits. It is, however, every bit as important. After all, making large profits in one area is worthless if we turn around and lose them in another. Those readers who have made it this far should give themselves a pat on the back for wading through important information even though it was less than entertaining. What we need isn’t always fun to get; but, it is always what we need.

I would also like to applaud GuruFocus.com for the willingness to publish an analysis piece that they are well aware is outside of the scope of what most sites of this type publish. It shows a true commitment to delivering real value to their readers even when that falls outside the range of what the readers are looking to find.

About the author:

Ken McGaha
Ken McGaha has been managing his own investment portfolios for over 20 years. On July 20, 2012 he launched the Self-Made Millionaire Tracking Portfolio with a portion of his capital as an aid to teach younger members of his extended family how he built his own investment portfolios and maintains them today.

Ken's Self-Made Millionaire website now has subscribers in at least 13 countries and the Self-Made Millionaire Tracking Portfolio has delivered a 28.36% annualized rate of return on capital between July 20, 2012 and June 21, 2014.

In late December of 2013, Ken added the Maggie's Money Mountain Tracking Portfolio to his website to show young investors with limited capital how he would invest and trade an account with $4,500 in order to grow it at a compounded rate of 12% annually. From December 30, 2013 through June 21, 2014, this account has produced an actual return of 26.05%.

Visit Ken McGaha's Website


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