In part 1 of this series, I described what I thought was the number one best investment (investment decision) that I have made within the past decade. This article will discuss what I ranked second.
Again in evaluating which investments/decisions I think have been the best decisions, I did not measure/compare them based solely on yearly performance numbers, and instead took an overall evaluation approach. The role the investment plays in the overall investment plan, the individual valuation/price, and other criteria were considered.
Please keep in mind that NONE of my selections are investment recommendations. And although some may still be below their intrinsic value, PLEASE do not rush out and blindly acquire the investments mentioned without any planning, research, or analysis. This should be considered a case study, so readers can see the thought and decision making processes I went through in the situations that occurred. Giving theoretical examples serve only to illustrate concepts & ideas, but discussing experiences (as in case studies) are more useful in showing exactly how the concepts & ideas can be applied to a real life situation. I hope the experiences can help other investors when presented with similar situations and opportunities.
The Investment [The Macerich Co]:
I purchased The Macerich Co common shares between October 2008 through to March 2009, at various prices between the range of $34 to $6 per share.
The Financial Crisis & Real Estate Crash
The investment was first purchased in the midst of the financial crisis & US real estate meltdown. Market values of residential & commercial real estate properties plunged horrifically across the United States. No one wanted to touch anything related to commercial real estate, especially within the US. It was very similar to the scenario described with the US banks in the previous article (Best Investments Of The Decade P1-3). Worse conditions were expected in the industries, and the general consensus among the public was that it was like investing into an upcoming disaster. Rows of foreclosed homes, empty store fronts, offices, abandoned warehouses, became even more common.
Credit problems & refinancing issues had plagued most Real Estate Investment Trusts (REITs). By September 2008, the publicly traded REITs & real estate related companies (who are traditionally seen as stable investments) eventually saw their stock prices plummet. Wall Street’s woes had infected Main Street. Unemployment rose and caused consumer spending to decrease dramatically. Many large name retailers in a wide range of markets went out of business in the difficult economic climate (Linens ‘n Things Inc, Circuit City Stores Inc, Steve & Barry’s LLC, Mervyn’s, KB Toys, Eddie Bauer, etc). Companies who owned retail properties such as malls & big box plazas were affected the most, as they saw major tenants disappear. They witnessed disturbing increases to their vacancy rates. To make things worse, in the years that preceded the real estate crash, mall operators in particular had been spending hundreds of millions in new development projects financed mainly with debt. Many also had multiple concurrent projects that were in development as well. They were already over-leveraged with debt ratios at the high end, before the financial crisis and real estate meltdown even began.
Commercial property owners quickly found it increasingly difficult to refinance (re-mortgage) their yearly maturing loans. Loans were typically hundreds of millions of dollars. For some of the larger companies, it was into the billion range. Many had found themselves on the brink of insolvency, as troubled banks were no longer willing to make the large loans (hoarding cash) related to real estate. The tight credit situation was the same with other lenders such as investment capital firms, insurance companies, etc, who were also experiencing financial difficulties of their own. Lenders demanded more onerous terms for refinancing debt. The decline in leasing income hurt their ability to make debt payments, and many real estate companies fell behind on loan payments. This lead to many property owners defaulting on massive sized loans, and entering in to bankruptcy protection (wiping out common shareholders in the process).
The Macerich Co (MAC), was a fully managed real estate investment trust specializing in regional malls. They focused on leasing, management, acquisition, and development/re-development of US regional malls. The company owned over 77 million sq ft of leaseable area consisting primarily of interests in 72 regional malls in the US. The company’s stock declined from highs of around $100 in early Feb 2007 (which was assessed to be way overpriced) to $70 by Dec 2007. In 2008, for the most part, real estate stocks declined less significantly than the broader market. Macerich’s stock price had declined to $65 by the fall, which was still overpriced but relatively closer to its fair intrinsic value.
Real Estate Sector Plunges
The commercial real estate situation continued to get worse, as retailers started to invoke co-tenancy clauses, which allowed them to pay less rent when anchor stores shut down. This caused many operators to sell properties in order to help pay down & refinance existing debts. In July 2008, mid-market retailer Mervyn’s, which operated about 175 midrange department stores were among the growing number of retail bankruptcies. In Sept 2008, the sharp decline in real estate related stocks began. People started to panic in the commercial real estate market and related stock sector, as they saw values plummet. All real estate investments were grouped into the same boat regardless of their individual situations. The 1 year return on the FTSE NAREIT All REIT index for the period ending Dec 2008 was a staggering -47.51%. The Bloomberg REIT Regional Mall index plunged -69% in 2008. To put this in perspective, the S&P500 and Nasdaq Composite returns were -38.63% and -38.22%.
By mid Oct 2008, high profile bank bailouts & takeovers negatively affected the entire stock market. Although refinancing became a huge problem for many REITS, Macerich had announced the completion of more than $500 million in refinancing in October. The price of the stock had declined to $34, down roughly -66% from its $100 high in 2007. At that price the company was well below its intrinsic value, with a decent dividend of approximately 9.4% (5.9% today due to reduction). After thorough research & analysis, I decided to take an initial position. The value investing approach used is in contrast to the common market timing approach of many average investors who try to buy at the stock market or share price bottom (and then attempt to sell at the market/price top). Because of the classic Shopper’s Problem that an investor faces (discussed in part 1) the rationale was to invest at a decently low price with a large margin of safety. If the price moved upwards to unattractive levels, then at least a small amount was acquired at a reasonable price. However, if the prices continued downwards, there was still cash left to purchase more at better prices.
As the bank troubles exploded, credit tightened further. Many smaller REITs were in dire financial condition, which added to the public perception that Macerich would also be unable to re-mortgage/refinance hundred of millions in loans (due in 2008, 2009, and 2010). Macerich had traditionally refinanced their mortgages with familiar life insurance companies and banks, whom they had long established relationships or joint ventures with. Those lenders were essentially their business partners and had already indicated their willingness to refinance. Macerich had earlier proven that refinancing was not going to be a major problem for them, and were unlikely to go bankrupt. Management had explained this during each of their quarterly conference calls. It was mentioned that negotiations were in progress (therefore could discuss details) and refinancing for 2008 was expected to be completed before the end of the year. Their funds from operations (FFO) were strong and increased in 2008 3Q compared to the previous year, along with lease prices. Despite all this, the stock price had halved to about $14 by mid Nov 2008. It was much less than 50% of its intrinsic value, with a P/FFO (price to FFO) of less than 3 times. The dividend was 23.9% (14.9% today due to reduction), making it a great deal. More shares were acquired.
Through the month of November, the company continued to reach agreements on hundreds of millions in refinancing of loans (11/18/2008 $380M). By Dec 2008, the stock price had trended upwards and remained for some time. Despite having refinanced $250M and retiring some corporate debt at a 45% discount (December), by early Feb 2009 the financial crisis deepened and the price dropped back to the $14 range. The banks had eliminated their dividends, and many troubled REITs were forced to suspended their payouts. Analysts voiced their opinions that Macerich was eventually going to eliminate their dividend completely as well. Their reasons were simply because it was too high a number. However, by law, US REITs are required to pay out at least 90% of their taxable income to their shareholders in the form of dividends. The only reason why the yield was high at the time, was because the stock price had dropped so low. It was not set high by management to “lure” investors.
To understand how dividend yields are calculated see the Dividend section of the Bank Valuation series:
Metrics related to the dividend (Bank Valuation III)
Note: With REITs, FFO and not EPS is of importance for the dividend.
Also see the article regarding high dividend yields, and why a high yielding dividend is not necessarily a sign of trouble:
Unreasonably High Yield or Unreasonably Low Market Price
Individual investors were now bombarded with news of companies eliminating dividends, more bank insolvencies (late 2008), and REIT financing troubles. However, Macerich was still successfully refinancing their loans (2/9/2009 $250M). They also reported their quarterly earnings with another strong FFO increase over the same period in the previous year due to strong occupancy levels. The price was pushed below $10 by the end of Feb and below $9 at the beginning of March 2009. Given the circumstances, the decision was to acquire significantly more shares between the $8-9 bargain level, which yielded 34-37% dividends (21-23% today due to reduction), with P/FFO multiples below 2 times. This was because such levels of cheapness had not been seen for years, and it was unknown if much cheaper opportunities would lie ahead.
Investors Hit The Panic Button
In late March 2009, the stock market had dropped to unprecedented levels. Investors hit the panic button with fear that they would lose everything. Macerich, like other REITs were largely held by retirees for income, and was sold off much worse than the overall stock market. The more the shares fell, the quicker & steeper the decline became, and the more people wanted to get rid of it. The share price had dropped to $6.90, which to most investors, was a heart stopping -93% decline from its $100 high (2007)!
It wasn’t hard to imagine what would be going through the average retiree’s head after they saw their shares drop by so much. Nor would it be difficult to imagine the nervousness of average investors who held the stock in their RSP/401k plans, and had been told to contribute monthly or biweekly (dollar cost averaging) into their plans at high prices right up until the decline.
Now the shares were selling for a tiny fraction of its intrinsic value. The price was ridiculously low and could not be ignored. The market had basically placed Macerich on the clearance rack. There was absolutely no reason why it should have been priced so low. Although the company was still expected to face some significant challenges, in-depth research & analysis showed that the fundamentals and business were still sound. The dividend, which was backed by solid income was 46.38% (27% after reduction), and the P/FFO was only 1.37 times.
The average investor had completely lost their mind and was behaving irrationally in all the chaos & panic. They threw away dollars for pennies. It didn’t help that the company’s stock was also considered “stocks that were deemed to be on their deathbeds” (by hugely popular investor site, MotleyFool) for no real reason other than a decline in its market price. However, this was not another Nortel Networks or Bear Stearns, as the company was actually worth MUCH MORE than the selling price.
Again, the Classic Shoppers Problem arose. But at that point, the thinking was that I wouldn’t really care if the price was to drop another $1 or $2, as the given price was already clearance pricing. However, if the price was to drop significantly lower (for example to the $1 level) I would re-allocate funds in order continue to attempt to purchase more below the current price. At a lower price level, it would significantly lower my adjusted cost base (ACB). Buyers in any marketplace want to pay the lowest possible prices. But there is no way of knowing if prices will rise or fall. At some point, buyers must decide to take what they can get, or wait for lower prices while accepting the fact that the lower price may never come. The decision was to acquire a very large stake during a period of immense pessimism towards REITs.
Unfortunately, the price dropped only to $5.80 by the end of March 2009. I didn’t acquire shares at the ultimate deal ($5.80), but the acquired prices were exceptional. At the end of the month (3/30/2009) the company announced the completion of more loan refinances ($446M). The company consistently showed that they had access to capital in a very tough credit marketplace, by refinancing millions in long term loans throughout 2008 and well into 2009. They also completed these ahead of schedule and at very good rates. Management had mentioned that they have always been respectful to the demands of capital and the hurdles it requires, by being conservative in the area of debt. This had helped them to maintain their strong financial condition, and was reflected in the fact they had fewer development projects to worry about than their peers. In comparison, on April 6 2009, General Growth (the 2nd largest mall owner in the US) filed for bankruptcy protection. It became one the largest real estate failures in history of the United States. General Growth had $27.3 Billion in debt, and defaulted on several mortgages as well as a series of bonds.
Although Macerich’s quarterly FFO in May 2009 increased again (over the same period last year), it was expected to eventually decline given the economic situation. They implemented a reduction in the dividend to $0.60/share, with a minimum of 10% in cash and 90% in shares. However, this was done in a shareholder friendly manner as it allowed investors to reinvest the dividend, but also helped to save cash in order to retire more debt. This was not unexpected, as payouts should correspond with the income from real estate operations (rent-expenses), much like in private residential/commercial real estate operations. People tend to forget that public REITs, which are traded on the stock exchange, are still real estate operators. In a particular month, if rent is delayed/missing or expenses are higher, then the owners would see less money. But we must also remember the REIT laws in relation to the dividend, so it wouldn’t have made sense if they eliminated the dividend completely without any material reason.
From June through to September 2009, the company announced a number of joint ventures, with their long term partners Cadillac Fairview and GI Partners. They had previously stated that they preferred the joint ventures (shareholder friendly) first in order to reassign money, rather than go right to selling shares. They also mentioned that selling shares was possible down the road, but not as preferable. From the end of August to Dec 2009, the price moved up and fluctuated at around $30 on positive joint venture events (not that previous news earlier in the year was any less positive). On Oct 27 2009, the company had a common stock offering and sold 12,000,000 shares for $383M. The shares increased unexpectedly above $35 by the end of year then returned to the $30 level at the beginning of 2010.
Impact & Additional Thoughts:
This investment served as a good exercise in applying a combination of almost all the investment principles & knowledge that I have learned over the last 10 years:
– Value Investing (not market timing/movement).
– Real Estate (leasing, cap rates, financing, commercial RE).
– Logical & rational thought VS emotion (mass panic).
– Independent thought (resisting the herd mentality and media).
– Thorough analysis (and looking for quantitative proof of management’s actions).
– Investment criteria (dominance, high quality, management, etc).
– Risk assessment (low risk, actual risks).
– Margin of safety (large enough to allow for error in intrinsic value estimate).
This situation was a real test of investor fortitude, as there was so much pessimism surrounding the US commercial real estate sector, stocks, and the economy. Many times the irrational herd is able to shake the confidence and emotional control of the individual investor. However, the solution to that is the accumulation of knowledge, which removes uncertainties. This is where the importance of understanding the business/industry, how it works/operates, the company itself, and the management who runs it, all come into the picture. In-depth knowledge from my own experiences in real estate, as well as additional research into the industry have been priceless in understanding the significance of certain details/information given in the company conference calls & quarterly reports. It is only then that real risks (and their impacts on the investment) can be properly determined and understood. The lazy investor’s method of just guessing and making risk assumptions (that certain problems exist or do not exist) which are not based on facts, is inadequate & dangerous. If an investor does not have enough information/knowledge, they need to first acquire and accumulate it for each specific investment. Otherwise for an individual investor purchasing REITs, this could have been an investment in General Growth rather than Macerich. The investor needs to be able understand what they are getting themselves into. They can then plan their actions based on potential expected negative events, and can clearly accept or reject the investment based on what they know.
The investment illustrates the problem of defining risk as anything else other than loss of investment capital. Many average investors define price volatility as risk, where they misperceive high volatility to be the same as high risk. As Benjamin Graham and Warren Buffett reiterate numerous times, real risk comes from not knowing what you are doing. That is why it is important to gain knowledge, and stick to your circle of competence.
Investigating the trustworthiness of company management is usually something that is overlooked by many investors. However, this situation outlines its vital role in the assessment of a company. Investors should not only look for details that appear on the surface such as their experience and history, but also a forthcoming attitude and their strategy in difficult times. Management should have quantifiable results to prove they are following their strategy. They should give an accurate account of the company’s performance and situation (not saying one thing but doing another thing, and no sugar coating).
In Macerich’s conference calls, the executives explained using a high degree of detail, why & how they were able to strengthen the balance sheet, maintain strong relations with lenders that they had done business with for years, and complete refinancing without problems:
– Signed new store leases, with starting base rent higher than expiring rent.
– Continued on mall construction/expansions, re-opening of redeveloped malls.
– Completed and opened new malls with new retailer openings announced (Forever21 and Kohl locations, wave of major tenants announced for new mall schedule for 2010 completion).
– Healthy balance of life insurance company debt in the portfolio, and representations within lines of credit that included just over 20 institutions (commercial & investment bank), all of which wanted to do more business with the company.
– Retailers who were going to replace bankrupt anchors (could not be named due to negotiation confidentiality), later revealed to be Forever21 and Khols. Mervyns empty locations did not become a significant problem.
– Able to refinance mortgages, with announcements made along the way.
– Shareholder friendly way of raising/saving capital first, instead of just selling shares right away (like most companies did).
How Is The Investment Doing Today?:
In February 2010, the company’s 2009 4Q FFO remained healthy but declined slightly from the same period in 2008. They also incurred a quarterly loss (not as important as FFO numbers), which was not unusual given that it was related to extinguishing more debt. It is not expected that losses be a sustained quarterly occurrence, as certain activities occurred more during one quarter rather than being spread out evenly throughout the year. Their 2009 full year FFO remained healthy, and the company reduced its overall debt by $1.36 billion. Quarterly FFO fluctuations are always expected, and therefore temporary dips or spikes due to one time events are not surprising. Lease rates, and development projects had progressed as expected. Refinancing activities have continued to be successful. In April 2010, the company raised $1.23 Billion in equity through a stock sale. Stock sales usually dilute shareholder value, but in this case the cash was to pay down some additional debt and take advantage of acquisition opportunities. They have also partnered up with Simon Property Group to acquire some of the class A properties of General Growth. The stock price had recently remained around the $37 level, which is roughly a 516% increase from the $6 bargain basement level. Quarterly dividends are still being paid. Although it was reduced from $0.65, to $0.60 (cash + stock), and then to $0.50 per share. The recent dividend ($0.50) marked a return to an all cash dividend, which indicates that the company’s financial position has strengthened. My dividend yield remains relatively high due to the extremely low purchase prices. However, it would not be unlikely that the dividend be reduced further if economic conditions worsen, but the REIT laws regarding dividends would still apply.
Its possible the price can see the bargain levels again, but given that investors are no longer in panic mode I don’t expect that kind of opportunity to happen again for a few years. The market has determined it had been a mistake to put it on the clearance table like it did. Going forward it is expected that the company will still face challenges, as the American economy is still very week. Consumers have not been spending due to the absence of a sustained economic recovery. Retail businesses have not seen prolonged sales growth or expansion, so it would not make sense that a mall operator would see tenant revenues/sq foot increase in any dramatic fashion. Nor should they see a significant increase in leasing activity. Macerich is expected to release quarterly earnings on Monday August 8, 2010. I do not expect anything significantly positive or negative, but continued progress as the economy continues to slowly recover. Macerich is well positioned to take advantage of economic recovery and consumer spending in the years to come.
Why Was It One Of The Best?:
I considered this one of the best investment decisions that I’ve made this decade for several reasons:
– Ridiculous price for high quality investment.
– Capital gain, but also an income component.
– Fills a large part of the overall plan.
– A good real life example and learning experience.
During the market’s momentary loss of sanity, the share prices were selling for tiny fractions of the company’s intrinsic value. They were ridiculously low prices for a very high quality asset. This allowed for large quantities to be purchased with very large margins of safety. However, the stock was not a “falling knife” (term implies the investment will never be a good one again due to real business factors). Nor was it a a company with serious financial problems. The Macerich Co is a very high quality real estate trust (operations, assets, management, finances). Canadians are probably familiar with the Cadillac Fairview Corporation. They are one of North America’s largest owners of high quality office properties and regional shopping centers in both Canada & US, with equity investments in RE companies & international funds. Some familiar landmarks in Ontario and Quebec include the Toronto-Dominion Centre and RBC Centre downtown (Toronto, Canada). Innovative malls include the Toronto Eaton Centre (Toronto), Sherway Gardens (Toronto), Shops At Don Mills (Toronto), and Carrefour (Laval, QC). I would consider the company to be a near perfect real estate investment. Unfortunately for Canadians, it is not publicly traded and is wholly-owned by the wealthy Ontario Teacher’s Pension Plan. It is also the pension plan’s crown jewel. Cadillac Fairview and Macerich have been partners on many other projects prior to the recent joint ventures, and have had a long term relationship spanning more than a decade, which is how I discovered the Macerich Co in the first place. The two companies have very similar business philosophies and values, that focus on high quality operations, assets, and management. I consider Macerich Co to be the American version of Cadillac Fairview. In fact, one executive was also a former Cadillac Fairview executive. This also illustrates the caliber of partners the company keeps.
In addition to being a capital gain investment of high quality & low risk (for a cheap price), it came with a very stable income component yielding a double digit dividend. The dividend would have to be eliminated completely or reduced to pennies, in order to make the yield an insignificant part of the investment’s return.
Another reason, is that the real estate crisis allowed me to to follow through on the prioritized opportunities that fit my overall plan. I always stress to my readers that an overall financial plan should always be made prior to any individual investment strategies/plans. My personal and prioritized investment opportunities (that would fulfill parts of my financial plan), was identified earlier and used as an example in my Investment & Economic Outlook 2009 article. Preferred shares (very rare occurrence) were placed above REITS (also very rare occurrence), which were considered the second highest importance. Execution of the plan resulted in acquiring the Wells Fargo preferred shares first, and then a handful of different REITs. Macerich, a REIT, filled a major component of my overall investment plan. It allowed me to line the portfolio with more top quality real estate related assets. Specific opportunities in real estate only comes around once every few years, so it was extremely important that the plan was followed.
The final reason is that it is one of the best real life examples & experiences that brought together everything that I’ve learned. It includes everything from knowledge, principles, mindset/attitude, to techniques, methods, and valuation. I discussed many of these components separately in my previous articles, but discussion of this investment situation gives my readers a real life example of how I went about putting everything together in practice. Many times examples are used with basic information/conditions, but this example illustrates the thought process and decisions made over time, in a shifting marketplace.
I hope you have enjoyed reading this article, and that you were able to gain some knowledge to take back with you! In the last article of this series I will discuss my third selection for the best investment / investment decision that I have made this decade.
Here is a list of books that will help you make better investment choices:
Securities Analysis: 6th Edition (Benjamin Graham)
[Not available at Amazon.ca ]
Thanks & Happy Investing! — The Investment Blogger © 2010