As we have a small break between earnings, it is the opportune time to introduce another Value Call.
If you’re new to Premium, we like to highlight “Value Calls,” a stock featured here that, in our opinion, is trading at attractive valuations.
We highlight these as often as possible outside our standard scheduled newsletters, as members feel they bring a lot of value.
However, let’s first review some issues that will likely impact the markets next week.
Iran/Israel conflict
There is a high likelihood, although never guaranteed, that we will see extensive volatility this week in relation to the Iran/Israel conflict.
This newsletter is not meant to be anything outside of an investing newsletter. For that reason, we’ll simply leave it at the fact that war and global events tend to shake the markets significantly. Look no further than the start of the Russia/Ukraine conflict.
It is likely due to global turmoils if we see red markets throughout the coming weeks.
We figured this deserved a mention. Again, we urge investors to take a long-term attitude toward their portfolios to avoid making short-term mistakes.
Dan’s moves this week
It was a relatively easy week for me. I simply added to my Alphabet (GOOG) and Boyd Group Services (TSE:BYD) positions in my cash account.
Usually, I am not one to hold cash, but I have slowly accumulated a 2.5% cash position from some added money to the portfolio and from some positions I sold (TD, BMO) that I have only partially allocated to new positions (National Bank).
As I mentioned, I am not one to hold too much cash. However, I won’t be in any rush to spend it next week with the issues going on globally.
If I don’t find anywhere to deploy the money soon, I’ll simply buy a HISA ETF or a money market fund with the cash.
Our Value Call for April 2024 – Granite REIT
It’s not too often that a Foundational Stock gets tagged as a Value Call. Usually, their consistent performance means they are typically in fairly valued territory.
That said, not even a Foundational Stock is immune to certain macroeconomic factors, and one company that has struggled to keep up with the markets is Granite REIT (GRT.UN). The reason for its struggles is quite simple – rate hikes.
We may sound like a broken record at times, but we always have new members joining our ranks. Hence, it’s important to reiterate some things, like why Real Estate Investment Trusts (REITs) have taken a hit in this high-rate environment.
Historically, REITs have done quite well when rates have trended upward. However, that is when rates rose at a much more stable and tempered pace.
The trajectory of interest rates had a considerable impact
The pace of rate hikes in 2022-23 surpassed anything we’ve seen in decades. That meant that REITs couldn’t keep up regarding rent hikes, so they found themselves negatively impacted right off the hop. Also, real estate prices dropped, and REITs were forced to reassess the fair value of their properties downwards – this led to a drop in net asset value (NAV), a key metric for REITs.
The severity of a REIT’s drop depends on its industry. For example, Office REITs have been the hardest hit, while apartment REITs have been the least impacted.
It appears rate hikes have stabilized, and rate cuts are likely on the horizon (although “higher for longer” is a real possibility; more on that later). We feel now is a strong time to look at REITs and other interest rate sensitive plays.
Granite is trading at significant discounts to historical numbers
The company is trading at a double-digit discount to historical averages. Ycharts has it trading at a 25% discount to historical valuations, and Morning Star has it trading at a 20% discount to its calculated fair value.
This doesn’t surprise us. Remember, the industry has pulled back because of the negative impact high rates have had on companies which carry high debt loads.
This means that the REIT industry has undergone a valuation reset. Despite being one of the best REITs in the country, Granite is no exception.
Today, Granite trades at $77.60 per share, up 2.88% YTD, trailing the S&P/Composite Index, which has returned 6.88% this year. It is also trading at a 36% discount to all-time highs of $105.79 (achieved back in January of 2022) and at an 11% discount to 52-week highs of $86.39, which it achieved last April.
Operations haven’t been impacted all that much
Investors are discounting this: despite a challenging environment, Granite has continued to excel operationally. Revenue, EBITDA, Net Operating Income, and Funds From Operations (FFO) all continue to climb YoY.
Here is an amazing chart that shows Granite’s performance in recent years. They haven’t missed a beat. Make sure you have images enabled!
Not only have they consistently grown the business, but the distribution has also been on the rise. The company owns a 13-year growth streak, the longest distribution growth streak among all Canadian REITs.As an added bonus, the company’s payout ratios against FFO and AFFO have also been on the decline. As of the end of Fiscal 2023, they sat at 71% and 64%, respectively – both multi-year lows and some of the best in the industry.
As described in our Foundational write-up, we must not forget that Granite is among the country’s best-capitalized REITs. So, while rising rates have led to higher interest payments and a hit to profitability, Granite has some of the lowest debt loads.
It has debt/equity and debt/asset ratios of 0.58 and 0.34, respectively, which are industry-leading metrics. Granite proudly publishes its debt metrics and make no mistake, the company has a strong balance sheet:
When one considers all this, one might start to understand why we believe that it is only a matter of time before Granite returns to its market-beating ways.
Today, Granite is trading at a 10% discount to Net Asset Value. While this may not seem like a lot, given some of the huge discounts others are trading at, we must remember that we are dealing with a best-in-class company.
It commands and deserves a premium, so it doesn’t make it any less undervalued than the rest. Before rates started to rise, Granite traded in the 1.2x NAV range, and it would not surprise us if that premium is reestablished once rates begin to drop.
The company’s portfolio is best in class
In our opinion, the risk-to-reward ratio with a high-quality company like Granite is enticing. We talked about the company’s strong operational performance and financial position.
What we haven’t talked about is how the company has an investment portfolio of $8.8B that is continuously being diversified. It has 143 properties across five countries (US, Canada, Germany, Netherlands, and Austria), totalling 62.9M square feet in gross leasable area (GLA).
One of the knocks on Granite in the past has been its overreliance on a single tenant, Magna International. Back in 2012, Magna accounted for 97% of gross leasable area, but the company has taken huge strides to diversify.
This isn’t the same company it was a decade ago, and today, Magna accounts for only 19% of GLA. Still a significant chunk, but Granite has been consistently lowering this number year over year.
Overall, we really like the company at these levels
In our opinion, Granite’s current price point is attractive. Granite’s weakness hasn’t necessarily resulted from the company’s operational performance or a poor balance sheet. On the latter, we’ve seen plenty of REITs struggle due to high debt loads, leading to many distribution cuts over the past couple of years.
This has pressured the industry as a whole, especially since the main investment thesis behind owning REITs is income generation. Investors love REITs because they typically have attractive yields and return plenty of cash to shareholders – usually with lower risk.
However, many investors were caught off guard as shiny, sky-high yields overshadowed poor balance sheets. As a result, many were surprised by distribution cuts.
When this happens, the entire industry suffers. Not only are REITs dealing with negative sentiment, but since guaranteed income yields have increased, investors have been able to lock in higher yields without any risk. If investing for income is your primary goal, why take risks with high-yield stocks when you can lock in strong rates and protect your principal?
Rates dropping should be a tailwind
All of these macro factors have played into Granite’s struggles. That is the bad news. The good news is that some macro headwinds are on the verge of subsiding. When rates begin to drop, that will be a catalyst for interest-sensitive industries such as REITs.
Guaranteed income yields may no longer be attractive enough to entice income seekers, and we may yet see another rotation back into dividend (distribution) paying stocks.
True, this may take time, but this is why we wanted to highlight Granite in particular. We are talking about a best-in-class stock that, despite its underperformance relative to the markets, still outperformed the majority of REITs throughout this downtrend.
It was also one of the best-performing REITs before rate hikes put a damper on the entire industry, and we believe it is in an ideal situation to lead the industry when positive sentiment returns.
This company has an industry-leading balance sheet and one of the highest expected growth rates among all TSX-listed REITs. It is also a Canadian Dividend Aristocrat with a TSX-leading 13-year dividend growth streak and one of the strongest payout ratios in the country.
The company has one of the highest interest coverage ratios and is one of the best positioned to outperform if rates stay higher for longer than expected.
A note about rates
Given Granite’s exposure to the U.S. and Canadian markets, it will be impacted by rate decisions on both sides of the border. This past week, the U.S. CPI print came in much hotter than expected, which reduced the odds of a rate cut in the coming months.
The Bank of Canada was a little more bearish, and also stuck in a difficult situation. Canadian consumers are struggling, but the dollar is also at the mercy of what happens in the U.S. – a rate cut here would devalue the CAD vs. the USD, which would not be good for Canadian businesses or consumers, and could fuel inflation further.
Today, the USD/CAD exchange rate is at 1.37 – close to decade-level highs, and the BoC is walking a tightrope. Regardless, one thing is clear – Canada’s economy is not in the best shape and we are worse off than our neighbours in the south.
We don’t want to sound doom and gloom, but that is our current reality. That said, eventually, rates will subside, and it’s unlikely that rates will rise (before first seeing some cuts).
If rates stay stable for longer, REITs are still better positioned, as rents can begin to catch up. As long as we avoid another period of rate hikes, REITs should start to see progress slowly.
While it may be tough to invest in beaten down industries and patience might still be needed in the short to medium term, in our opinion, Granite provides an attractive risk-to-reward ratio.
