Stock Picking with a Focus on Financials
TWST: Please start with a brief history and overview of Phocas Financial.
Mr. Schaff: We're a small team. Primarily, we do our own fundamental research. We do it pretty much the old-fashioned way, reading annual reports, 10-Ks, 10-Qs and working through the numbers. We focus on valuations and try to seek what drives valuations. Obviously, they vary all over the map and across sectors. And as we do that today we tend to be value-sensitive, so we're probably considered a value shop. It's really sort of nuts and bolts, it's grinding every day over financials and a lot of data.
TWST: We're focusing on small-cap value investing today, so would you describe your investment strategy in that regard, and give us a snapshot of the portfolio?
Mr. Schaff: It probably helps to understand where we came from. I sat on and chaired the investment committee for a large public pension plan. I've been at this since 1986. One of the things that always struck me as part of the industry landscape is that a lot of money managers come and go, styles come and go, but at the end of the day, when I was looking at the institutional market - which I sat on both sides of - one of the things that I noticed is, what's the efficiency of certain styles, of small cap versus large cap, international, etc.? Obviously, small cap has greater inefficiencies, stocks that are not being followed by sell-side analysts, and that clearly does result in the potential for higher active alpha. So that was the first part of our analysis. The second part is, if you are in this long enough, no matter how smart you think you are, very few people can time the market. Despite that, every now and then someone gets lucky. But if you're in this long enough, it is very difficult to forecast and predict sector movements accurately over multiple market cycles. We are not economists, therefore we try not to predict the economy. Even if you have opinions - and we do - you might as well flip a coin half the time. We try to reduce the impact of macro decisions that we really have no control over from our standpoint. That's basically saying, OK, at the end of the day, we're going to be in all major sectors. We're shooting at a benchmark. Institutional portfolios are all shooting at a benchmark, in our case it's the Russell 2000 Value Index.
When you look at the composition of the index, you know there are times when a certain sector call will do well. You can almost see what will happen, for example, with financials in 2008, 2009, because of the fact that they got killed. When you have an index that has an almost 30% weighting in financials, if you make the right call at the right time on that, that is a clear way of outperforming. Our feeling is that, given that you might have a strong conviction but at the end of the day you don't know when financials are going to turn - you don't know why or what the motivation is or when Chairman Bernanke is going to make the call - our call is about finding the best valuations within the financials, and all of the other sectors represented in our benchmark. So what we try to drive to is when people look at our alpha performance - you can get it from stock selection, you can get it from portfolio allocation, etc. - a disproportionate 95% each year of our alpha is from stock selections. So when people hire us they know they're getting stock pickers. That's what we are, that's what we want to be known for, that's where we bring value. And at the end of the day, that allows us always to be competitive with the benchmark, no matter what.
If you are an institutional investor, you theoretically have a very long-term time horizon, and I can understand the short-term risks and volatility issues, but if you really focus on the long-term return, why anyone is paying two plus 20 for effectively less than a long-term equity return when you're supposed to be in equities long term - that just boggles my mind. Why wouldn't you just pay 80, 90 bps, whatever it might be? So there is a value proposition there, but part of that is really consistent with the institutional time horizon that I talked about. More and more institutions almost have a retail mentality, which is what drives hedge funds, because they can't stand the volatility. And yet if you look at the stability of the well-managed long-only portfolio over the long cycle, as long as you adhere to it, you come out ahead and at a lower cost. So that's the basic premise for why we drive to a value portfolio.
For portfolio composition, I won't say we're rigidly sector neutral, but we tend to stay well within plus or minus 2% to 3% of the sector weights of the Russell 2000 Value Index. We're already heavily weighted to it. So if you think of that composition, when you have 30% of your portfolio in financials - one thing I will say is we are very strong in financials, we have a long history of following banks, insurance companies, we follow the real estate investment trusts, which are a growing portion; they're about 12% of the benchmark today. There are many value managers who don't know REITs, because they're sort of a hybrid asset class. It makes it tough. There are some managers who won't even bother buying them, just because they're not a generic equity. Imagine a small-cap value manager saying they don't invest in industrials, which have about the same weighting in the Russell 2000 Value Index as REITs.
TWST: Your firm has a proprietary model for evaluating REITs. Would you tell us about it?
Mr. Schaff: What it comes down to is that everything about the equities market is about supply and demand as much as it is about fundamentals. What drives valuation many times is the perception of REIT ownership. In their early history, the REIT law that was applied in the 1980s was about trying to get real estate into retail investors' hands. What it really resulted in, however, was during the S&L crisis a lot of the S&Ls and banks effectively tried to offload the bad assets to mortgage REITs. And so it got tainted by that, and the mortgage REITs, at the end of the day, a lot of them blew up, because they were bad to begin with and they were highly leveraged. Interest rates went up, and valuations cratered, and they were basically caught. The modern REIT era - where they are mainly equity REITs, they are self-managed, they actually own the underlying assets, they actually lease and manage the properties, different types of properties - started in about 1993. So REITs have been around for a long time, but the modern equity REITs really started around 1993. And the number of REITs that came into the marketplace, and the better managed ones, the ones that have strong management teams, they're shareholder sensitive, they're shareholder activists in some cases. Milton Cooper of Kimco Realty (KIM) came in, Simon Property Group (SPG), Boston Properties (BXP) , Vornado Realty (VNO), etc. - a lot of the big property owners, they all came in the 1990s and the market expanded quite a bit. When that happened, they were being promoted early on by some of the retail brokers who were selling them on the dividend yields. Most of it's tax-sheltered dividend; they are a single-taxation entity at the shareholder level, which is a huge advantage. They were liquid, which a lot of the private REITs were not. And you could get into shopping centers, you could get into offices, you could get into apartments. It's a lot easier selling an apartment building in Atlanta by selling shares of Post Properties (PPS) than it is by actually selling the property privately, which could take you a year and a half. So there was a lot of incentive.
Since you have a large retail base, a lot of the retail investors basically look at dividends. That's pretty much how they view it, that's how they value it, that's what they want. And so they don't care whether their internal rate of return or capital gain is 15% or 20%, as long as they know they're getting their 6% income. So dividend discount models tend to work and are very effective in representing that valuation.
Then on the other hand, we have private real estate investors. They don't really care how good the management is, they simply want to buy assets on the cheap. They don't mind buying them on Wall Street versus Main Street, but at the end of the day the net asset value, the cap rate, the typical real estate valuation play comes into being, and allows the institutional funds that actually have direct, private real estate funds - a lot of them have opportunistic funds where they say, wherever we can buy the cheapest real estate assets, we'll go. And so there are times when REITs are cheap, and you'll find a lot of these opportunistic funds dipping into securitized commercial real estate.
The third group is the institutional market, institutional equity, hybrid market, which is, at the end of the day, Merrill Lynch, Citigroup - whatever they buy, the securities are in the index funds. They are always playing a relative-value game. You always own something. It's just a question of what stock or sector you own. That's where you get into a traditional free cash flow, or in this case for real estate it's funds from operations. Since you want it normalized between sectors, you want adjusted funds from operations, because obviously capex for office buildings is much higher than for storage units; you have very different capex requirements.
And so you put those three different valuation models into play - relative price to assets; NAV valuation, which assumes cap rates, which are tied to current bond yields; and then a dividend discount model, which takes into account various discount rates and equity risk premiums, etc. - you basically use this as a weighted model. And by doing a weighted model, you're reflecting where you are in the securitized commercial real estate cycle, which actually moves in front of the direct real estate cycle, because people who are anticipating will be able to move more quickly in the securitized market than in the direct real estate market. And because you can anticipate proportionately who's going to be where, if dividend yields are going to be low, people are going to be looking for higher yields. Because retail money flows to it are obviously reflecting retail demand, you can weight that portion of the model higher, and that will give you a fair value based on the composition of what we believe is probably fair value represented by potential buyers that are usually active in that marketplace. We can compare that against the current value in public markets. So you're looking at those three valuation models, you're weighting them, and you're looking for discounts or premiums to fair value.
TWST: What are a couple of your favorite REITs for someone looking for a small-cap value investment?
Mr. Schaff: Probably the cheapest one right now is one that is heavily out of favor. There are actually two answers to that question. One is, what's our best idea, which is what might move this year, and what's the cheapest valuation in our minds, given the underlying fundamentals? I'll start with the second, which is what we would consider to be one of the cheapest stocks out there, and that's First Potomac (FPO). They're an industrial REIT outside of Washington, D.C., in the Maryland and Virginia area. The reason we like that is because everyone hates Washington, D.C., and that whole area right now. They think it's very transient, it's out of favor, they can't get rental rates up, occupancy is weaker than the peer group - all the things that drive valuation down. And fundamentally, not a lot of that is true, so there's a disconnect between what is actually happening on the ground versus what investors perceive the stock is because of the area. And the reason is, they're looking at the area and not what the company is specifically doing with its properties - they're leasing and actively managing the assets. That type of disconnect is a valuation disconnect. We think it is probably about 20%, 25% undervalued. We think it has much better growth prospects than the market is giving it, and in the meantime you're being paid a 6.5% yield. That, to me, is a good deal. So that gives you an idea of, when you look at these companies, if you have the time frame, then you can afford to wait.
TWST: That's the cheapest. What's your overall favorite REIT name?
Mr. Schaff: Right now it's a company called CubeSmart (CUBE). It's a self-storage REIT led by the former Storage USA executive Dean Jernigan. He came close to retiring, but started doing the same as the Storage USA play, which is that he looks at major metros, he buys assets in those major metros, and what he's looking for are large populations that allow for growth in the self-storage space. And the reason he's trying to do that is these days, people are demanding more, especially some of the commercial consumers of storage; they want more access, they want more services, because some of them do use temporary, transient-type of storage capacity. And so what he's determined is the whole basis for why he's trying to add on services as an additional way to generate cash flow. But just the transformation from one-off locations where you don't have as much critical mass, you can't allocate overhead and management oversight, you can't use the competitive resources you have with multiple sites and geography, a basic reduction of costs - at the end of the day, that's what he's transforming the business into.
That transformation will take the next three to five years. In the meantime, each year occupancy is expected to increase 100 basis points a year, cash flows increase. Once he gets to a certain percentage of occupancy he'll be able to raise prices, maybe not this year, but probably by next year. All of these things will generate, and if these are at least 35% to 40% levered, all of a sudden your excess cash flows and AFFO will start increasing. That's the kind of valuation that is good and fundamentally is attractive within a space that's not well understood, but getting better. So the difference in valuation between CubeSmart and, say, Public Storage (PSA), which is the dominant player in the storage sector - part of that is that they get a huge liquidity premium because they're dominant. But at the end of the day, the valuation discount is probably 20%, 30% to their peers. You can argue whether that is justified or not, but I don't think so.
TWST: Outside of REITs, what are some of your other top picks?
Mr. Schaff: Banks seem to be everyone's darling now, but they weren't always. We like small-business banks, like San Jose's Heritage Commerce Bank (HTBK). Basically they're a business service bank in Silicon Valley. What's interesting is a lot of people assume when you talk about a business bank that they're catering to technology companies. They do somewhat, but they really cater to the service companies that support the technology companies - the legal firms, the accounting firms, all those things. It's much more mundane. There are two things about them that we like. One is, it's selling at a discount to book value. We actually have our own valuation methodology, which is really a liquidation valuation. We looked at the different loan lines that they have, and we take different types of haircuts for them based on the type of risk profile of those loans so that would suggest book value. It's been done before, it's nothing unique, it's just how we assess risk of these banking institutions. By doing that, we always have a risk-adjusted valuation approach that is fairly consistent over time. So we know how much risk these banks take and when they take more risk than they used to, or when they take less risk. That's one of the reasons for all of the banks we own usually being comfortable investments for us, it's just a lot easier, because we actually do look at the balance sheet quality.
This one is a perfect example of one that is trading at a substantial discount to book value. It has nine service branches in Silicon Valley, and it's actually making money, and at the end of the day it will make more money. It's one of the best geographies. It's relatively small. It's likely to get taken out at a premium, because if you want a presence in Silicon Valley, that would be the fastest way. They have nine retail branches already, you don't have to worry about where to rent a branch office, which you can't find good spaces for right now, so it's a very convenient way. Would someone pay 1.5 times book for that? Yes, probably. You get a great operating company that's making money, that does not have loan issues, with great leverage to a locality that a lot of people desire.
There are a couple of banks like that, but they're always the smaller banks, and they're not really followed by the sell side. You do have liquidity issues with that, so it's not something you should just jump into for the short term. These are not trading stocks. You have to believe in what they're doing and understand you either get to the point where they get big enough liquidity that you can exit, or someone takes them out and you can exit.
TWST: You're not necessarily making sector bets, but are there any sectors that you're especially concerned or cautious about right now?
Mr. Schaff: The biggest underweight we have is utilities; we're 2% underweight. Utilities had a great year last year, because they were the safe play. But fundamentally, they rely on rate approvals by the utility commissions. And all you have to do is look at the utility commissions around the U.S. to know they're not excited about allowing high returns, but they want you to make all the capital improvements as quickly as possible. So it's always sort of a jousting match. Utilities are stable in the sense that they do allow a "fair" return on equity, and equity is generally 45% of the balance sheet. When you submit a rate proposal to the commission, after much meeting up for a review, they usually allow 10% these days, and what they end up with is probably like 8.5%. If you say the equity risk premium is about 12% to 13%, your debt is sitting around 5% or 6%, you're barely earning your cost of capital, so it feels like a nonprofit. That's the issue right now with a lot of utilities.
The only exception to that rule is the water utilities, because water utilities, if you think about it, your water bills are substantially less than your power bills. The power bills, they're the ones that everyone writes about, they're the ones that everyone talks about. Meanwhile water companies are sort of like the good guys. They're always making water pure, and it's always reliable when you turn on your tap or your shower, there it comes, they are the good guys. When they come in with their 10%, they don't get debated. If you see your rate increase, it's only increasing by a few pennies anyway, you're not even seeing that big of a difference, so very few consumers complain about the water bill, as long as they get it. And so generally water utilities get 10%. It's really interesting. And because a lot of municipalities own it, it's a very fragmented market. They're actually growing because they can go in and often buy these from the municipalities, and they immediately get a return, because the buyout is at much more generous rates. And so at the end of the day, that is a continuing consolidation. They continue to get a fair return on their capital allocation, and so it actually grows earnings. It's quite a different utility model than electric and gas.
And what you'll notice is, they trade at a premium to the other utilities, and they historically have. So that's why I say, if you don't understand what you're evaluating, then you don't necessarily get the valuation that you should look at. Otherwise if you just lump them in with all the other utilities, you potentially come up with a misleading conclusion. But if you look at their peer group, you can find relative value, and they represent a portion of capital allocation of utilities. That's how we look at it.
TWST: Is there anything you'd like to add in terms of what sets your firm apart from your peers or competitors?
Mr. Schaff: We're a boutique. I think we're very good at what we do. We are probably better at certain sectors, financials included, because we know them very well. I have a background in engineering and technology, so I know that space fairly well. So there are certain sectors we probably do better in than others. Financials would be number one. We have not had a year when we did not beat the benchmark return for the financial sector. If we start out of the gate and the portfolio has an advantage, I think that's a good advantage. That's a critical aspect. I think there are certain sectors that are really tough, and we just have some knowledge on how we try not to overplay our hand; for example, health care and biotech. It's really hard. So are discretionary and specialty retail - very difficult. So part of that is figuring out ways to subsidize your weakness, and that's what we try to do. But we do participate in all of the sectors in the small-cap value benchmark, and that's actually helped us be able to beat the Russell 2000 Value Index consistently with minimal of tracking error. And I think we really enjoy what we do. It's a dedicated team, it's a cohesive team, I think that's what you need in this world to get ahead. We're very committed to being a fiduciary and doing the best that we can for our current clients at any given time.
TWST: Thank you. (MN)
William Schaff, CFA
Founder, CEO & Portfolio Manager
Phocas Financial Corporation
980 Atlantic Ave.
Alameda, CA 94501