The five-year thought experiment
Posted on October 19th, 2022
The Border to Coast Listed Alternatives Fund focuses on listed alternative assets that are aligned to long-term growth themes such as renewable energy, digitisation and urbanisation. In this article, Portfolio Manager Ryan Boothroyd discusses how taking a five-year mindset helps to reinforce the Fund’s focus on quality assets at reasonable valuations and maintains discipline in the face of short-term market volatility.
Whenever I consider making a material change to the portfolio, I run through a thought experiment. Imagine that from tomorrow, all global stock markets will be closed for the next five years. No other changes to society will occur. People will continue to work, companies will continue to operate and the wheels of life will continue to turn. Would the decision still be correct?
The point of the thought experiment is two-fold. Firstly, it reminds me that my job is to make the best long-term decisions for our investors even if that may occasionally result in some short-term pain and uncertainty. Secondly, it underlines the importance of targeting high-quality and reasonably priced companies or asset portfolios that have the potential to operate strongly over a long-term time horizon.
The current market environment offers an interesting opportunity to apply this framework as share prices continue to move erratically. There is substantial short-term uncertainty, however for long-term investors there is the possibility of substantial value. The difficulty is rewiring your brain to focus longer term over the next five years.
Below, I have outlined two individual positions from the portfolio that I believe pass the five-year thought experiment, even if the short-term outlook feels treacherous.
Tritax Big Box [BBOX]
The UK logistics sector has been through something of a boom for the past five years. Huge demand for online shopping collided with a lack of quality warehouse supply, pushing up valuations and squeezing yields. At the peak, yields on many market transactions in the sector were below 4% and vacancy rates were close to zero. If you were a business and you wanted a warehouse for your online operations, you had to pay up.
Many investors would have told you that the sector was running hot six months ago. Most analysts and commentators expected a gradual moderation over time, with yields slowly expanding as supply increased or higher prices tempered demand. A below-market return on logistics stocks for a period of time seemed plausible as the market realigned and we were net sellers in the Fund.
Comments from Amazon’s earnings call in May about slowing its real estate expansion soon prompted the first stage of the necessary reset, but the recent explosion in UK bond yields has added a further dimension and the former darlings of the UK REIT sector have fallen from grace. In less than six months, we have experienced a 50% reduction in stock prices for leading logistics REITS. With my five-year mindset engaged, this seems to present an attractive investment opportunity.
Let’s consider the numbers. BBOX generates around £200m a year in rent with average contracts stretching for 13 years. It has a blue-chip client base including Amazon, Ocado, B&Q and Tesco. At the start of 2022, the Company was valued at around £4.5bn, or an implied rental yield of 4.4%. Not re-mortgage-your-house-to-buy-shares value, but in the context of UK 10-year yields of around 2.5% at the time, and considering the element of inflation protection offered by rent increases, still a healthy spread.
The market was tight, rent was growing at double-digits and new developments were coming online substantially pre-let.
Fast forward to today and market fundamentals have changed warranting a moderation of expectations. Debt costs are expected to increase due to rising rates and demand will likely slow as retailers scale back their online ambitions. However, BBOX utilises leverage sparingly and given the critical importance of e-commerce, the trend towards reshoring and supply chain efficiency, demand is unlikely to collapse.
In addition, the supply outlook remains highly constrained and BBOX owns a large proportion of the available logistics land bank. Further, the Company is now valued at £2.4bn, or an implied rental yield of 9% on 2022 rent roll, a valuation not seen in quality industrial properties since the early 1990s and never experienced in the internet retail era of logistics*.
In the short-term it is difficult to know what will happen to the BBOX share price and there may be further pain ahead. But, from the information above, we can be relatively confident that the range of long-term outcomes is more positive than negative. The Company has a long track record of double-digit rent roll growth through new developments and contractual increases and analysts expect this to continue.
If we were feeling particularly pessimistic about the market, we could assume 5% a year growth in rent (this is almost guaranteed by contractual uplifts in existing contracts). We might also say that given the increase in gilt yields the heady days of 4% yields are long behind us and instead a 7% yield (last seen in the midst of the global financial crisis) is more appropriate. This would imply a valuation of around £3.6bn or almost a 12% pa return for the next 5 years when dividends are included**.
“The point of the thought experiment is two-fold…it reminds me that my job is to make the best long-term decisions for our investors even if that may occasionally result in some short-term pain and uncertainty [and] underlines the importance of targeting high-quality and reasonably priced companies or asset portfolios that have the potential to operate strongly over a long-term time horizon.”
Molten Ventures [GROW]
Molten Ventures is a listed venture capital fund that owns stakes in early-stage, high-growth businesses. Names you may recognise include Cazoo (online car market place), Revolut (payments app), Perkbox (employee benefits) and Crowdcube (crowd sourced fundraising platform). The Company’s portfolio is large with around 70 positions spread across sectors and growth stages.
High growth, early-stage investing has not had a pleasant year, with the technology-heavy NASDAQ index down -35% from its recent high and the Ark Innovation ETF (the bellwether vehicle for speculative technology companies) down over -70%. If anything, given its size and relative illiquidity, Molten has fared even worse, currently trading at around 270p per share, down from a peak of almost 1200p.
The market narrative goes something like this. Interest rates are rising rapidly which devalues the cashflows of high-growth technology businesses that generate most of their revenue a long time in the future.
In addition, the cost of debt and equity funding for start-ups will increase substantially as the investment opportunity set shifts, so financing cashburn will be tricky. If I can buy a UK gilt that pays close to 4% a year for 10 years, what interest rate do I need to receive to justify a loan to an as-yet-unprofitable start-up? Inflation and the potential for economic recession add further headwinds to early-stage companies who are typically less resilient and often rely on consumers for a sizable chunk of their income.
However, from a long-term investor’s perspective, is the value of the Molten portfolio in five-years’ time likely to be significantly higher than it is today?
“As long-term investors, and by focusing on quality and price, we can have greater confidence in opportunities created by day-to-day gyrations where short-term fear can push prices to irrational extremes…”
Let’s think about some hypothetical numbers. The current implied valuation of the portfolio is around £470m or 2.5x annual sales for 2021. Now let’s look five-years out. Firstly, after a perilous period for start-ups, let’s assume that 30% of the portfolio is unable to finance itself, goes bust and is now worthless. The remainder of the portfolio scrapes through with a historically underwhelming 20% pa revenue growth – a pale shadow of the long-term average of over 60% pa which Molten’s portfolio companies have delivered since 2017.
Even if we assume the multiple applied to sales increases to only 3x the implied portfolio value would be £1bn. That is double the current share price or a 16% pa return between now and 2027***.
There is no certainty in financial markets. This is particularly true over short-term time horizons. No one can tell you with any degree of certainty what might happen to a given stock, bond or commodity over days, weeks or months. However, as long-term investors, and by focusing on quality and price, we can have greater confidence in opportunities created by day-to-day gyrations where short-term fear can push prices to irrational extremes.
By maintaining a strong stomach and looking further into the future, we can utilise this to our advantage, tilting the odds slightly more in our favour.
** This is a hypothetical example and such forecasts are not a reliable indicator of future performance.
*** This is a hypothetical example and such forecasts are not a reliable indicator of future performance.
Positions in Tritax Big Box and Molten Ventures are held within Border to Coast’s Listed Alternative Fund, managed by Ryan Boothroyd.Back to all News & Insights