This Market Factors starts by making income investors happy with a bullish, M&A-focused bull case for REITs and moves on to a bear case for developing world equities. The diversion covers a terrifying list of painful surgeries and there’s Quick Hits as always.
Income investing
Scarce REITs make takeout prices higher
CIBC analyst Dean Wilkinson thinks investors should brace for more merger and acquisition activity in the REIT sector and that’s never bad for performance.
Mr. Wilkinson emphasized that the value of REIT M&A activity has exceeded C$21-billion in the past two years and he sees no signs the trend is slowing. There is a clear discrepancy between public markets that have had depressed valuations since post-COVID higher interest rates and private investors, which are seemingly valuing the steady income of real estate assets more highly.
A lack of supply explains why public REITs are getting higher acquisition prices. Three REITs are removed from public markets by private owners per year on average but until recently, there was enough IPO activity to maintain a three-to-four per cent weighting in the TSX. The recent lack of new REITs, combined with sector underperformance of the index, has seen the real estate weighting fall to 1.4 per cent. There are now fewer REITs for private investors to choose from and scarcity raises prices.
Mr. Wilkinson sees a bifurcation in current valuations where his favoured Boomers and Consumers (seniors housing and retail) theme is marginally more expensive than the historical average whereas the previous sector leadership, Beds (residential) and Sheds (industrials) are trading at a discount in terms of price to net asset value (P/NAV) and price to funds from operations (P/FFO).
The analyst argued that net operating income – the sector’s definition of profitability – is currently more important than interest rates in the current market.
The recent acquisition of First Capital REIT by Choice Properties and KingSett Capital will benefit the remaining retail REITs – RioCan, Primaris, Smart Centres and Crombie – and in that order, according to Mr. Wilkinson.
The analyst does not see imminent takeover activity in the retail REIT space but I carefully watching the apartment subsection. Recent deals in the sector should create investor flows into Canadian Apartment Properties REIT and to a lesser extent Killam and Boardwalk. If buyout activity does occur, Mr. Wilkinson sees Killam as the m most likely candidate followed by Boardwalk. He considers deals unlikely in the industrials and seniors housing subsections.
Global equities
Myths of EM investing
Morgan Stanley equity strategist Jonathan Garner published a report last week on emerging markets stocks important enough that the conclusions might result in considerable pain in the developing world as global investors withdraw funds.
Mr. Garner notes that for U.S. investors, and by extension many Canadian investors, the alleged benefits of the emerging markets equity asset class are diversification and higher growth. I use “alleged’ because the strategist found these benefits to be more or less a myth. He writes bluntly that “the case for the existence of an EM equities asset class is weak.”
Mr. Garner believes that developing world countries should no longer be viewed as a distinct asset class. In an increasingly multipolar world, organizations like the IMF and World Bank that used to underpin and organize the direction of emerging economies no longer hold as much power – it’s now more of an every-country-for-itself environment. There are strong individual investment opportunities in the developing markets, but investment in the sector as a whole no longer makes sense.
In terms of performance, risk-adjusted emerging markets equity returns have been very weak over the past decade, underperforming the U.S., Japanese, FTSE 100, and MSCI Europe stocks. Even more damning, Mr. Garner found that emerging markets positions neither lowered volatility or increased returns for portfolios otherwise composed of developed world stocks. (Emerging markets currency exposure did have diversification effects, however).
Mr. Garner argued that the belief that emerging markets returns can only improve from here are misguided. The world is shifting into smaller distinct trading blocs and the traditional relationships between asset classes, including the degree of correlation between equity markets, no longer apply.
Mr. Garner recommends copper plus Japanese and European equities for diversification.
Canada and Australia have unique relationships with developing world equities. Commodity-heavy stock markets in both countries have been, at times, highly correlated to the MSCI Emerging Markets index because developing world economic growth requires more resources, most often because of higher manufacturing components. But the correlation has been low for both the S&P/TSX Composite and S&P/ASX 200 for the past few years.
Doctors and nurses prepare for surgery at the Royal Jubilee Hospital in Victoria.JOHN LEHMANN/The Globe and Mail
Diversions
Most painful surgeries
Somebody named Discovery Matt on Instagram posted a list of the top five most painful surgeries to have. I don’t know how credible he is but I was horrified anyway. Since misery loves company, I will recount them here.
Number five is open heart surgery. It involves sawing through your sternum and a recovery period that involves pain with every breath. No thanks.
Number four – and this is ridiculous – is limb lengthening surgery. The leg bones are broken and then slowly pulled apart so that bone can grow into the gaps. People who do this unnecessarily are crazy.
Number three scares me the most – burn debridement. This involves scrubbing burnt skin off so that healthy skin can grow. I’ve had minor burns before and the pain is way out of proportion to what it looks like.
Number two is full mouth reconstructive surgery and I don’t want to think about it too much since it involves bone grafts into the jaw. Moving on.
Number one is spinal fusion surgery and a bit of a surprise. Not that I thought it was pain-free but there are two players on my beloved Detroit Lions who have had this surgery in recent years and I had the impression it was more of a rudimentary procedure despite the risks to nerves.
The essentials
Looking for our updates on market movers, analyst actions, stock technicals, insider trades and other daily, weekly and monthly insight? Click here to visit our Inside the Market page.
Globe Investor highlights
Bird Construction provides a lesson in letting your winners run and not selling to insiders, says the Contra Guys’ Philip MacKellar
A Number Cruncher featuring 10 fast-growing Canadian companies trading at reasonable valuations
Quick hits
I don’t have much novel to say about PM Carney’s plans for a sovereign wealth fund. The issues seem obvious. Is it good to strategically increase domestic investment? Yes. Are there opportunities and expertise available? Yes. Are there risks that political tampering causes a misallocation of resources? Sure.
Morgan Stanley strategist Michael Wilson noted that the market is currently rewarding stocks with high capex-to-sales ratios and I suspect this might be a good example of a chicken and egg logic issue. The inference is to screen for stocks with high capex-to-sales numbers and wait for the outperformance. My suspicion though is that the stocks everyone has loved for a decade or more – Microsoft, Apple, Amazon, and Meta Platforms for instance – just happen to be spending a lot of money currently because of AI. In other words, they are not outperforming because they are spending a bigger share of revenues, that’s just a coincidence. I, for one, prefer to buy stocks that are receiving all the money the hyperscalers are spending. I’m looking closely at Corning Inc. (GLW-N) right now.
Read this week’s earnings and economic calendar here