In my previous post I suggested that we may be in a structurally deflationary environment, especially since the principal tool that central bankers are using in order to promote inflation–i.e, quantitative easing–may be having the opposite of its intended effect. At the outset of 2014, Bloomberg polled professional economists for their predictions about where interest rates would be headed. All of them, without exception, predicted rising rates. The only question was how high they would go. The prognosticators agreed that the benchmark 10 year Treasury yield would rise to at least 3% by now, and the only disagreement was how much closer to 4% yields would get. So much for that prediction. Yields on the 10 year Treasury have now dipped below 2.6%, down from the 3.01% high of late December 2013.
In an environment of rising rates, bonds and equities with bond-like characteristics–utilities, real estate investment trusts (REITs), master limited partnerships (MLPs), etc.–tend to perform badly. New bonds pay higher yields than older ones, so the prices of the older ones drop. As interest rates go up, investors can get higher yields without the additional volatility risk of equities, so equity “bond substitutes” become less desirable in comparison to the new, higher yielding bonds. Furthermore, the financing costs for REITs and MLPs increase, since they return most of their profits to shareholders and rely on borrowing in order to invest and grow.
Just as interest rates have confounded predictions thus far year to date, so has the performance of bonds and bond-like equities. Consider Digital Realty Trust (DLR). Digital Realty is one of O’Brien Greene’s more contrarian picks, which we started to buy at the beginning of 2014 and to date the stock is up about 17%. the company is a real estate investment trust that owns and operates data storage facilities for a wide range of industries across the globe. Digital Realty’s strong performance this year comes after some previous management turmoil and a stock sell off, which made the price attractive. The digital storage business has become somewhat commoditized, Digital Realty’s growth had slowed in comparison to its smaller competitors; the company is the largest real estate investment trust that provides data storage. But we thought that investors were exaggerating the effects of these trends on Digital Realty’s prospects, and we were looking for a REIT and liked DLR’s exposure to the cloud-computing theme. Here is DLR’s price performance over the past two years, compared to the S&P 500 Index and the Vanguard REIT Index fund (VNQ). REITs generally have lagged far behind the S&P ever since the big jump in bond yields back in May 2013.
Digital Realty’s performance has contrasted markedly with the broader tech sector, which includes many of its data storage clients. Here is DLR relative to the tech-heavy NASDAQ index:
Digital Realty pays a big yield: over 6% when we started buying, and now about 5.7% annually. This provides the stock price with something of a cushion, and the company has a strong history of increasing its payout. It recently increased the 2014 dividend 6.4% compared to last year, which is now at $3.32 per share. The company’s cash flow and payout ratio suggests that the dividend is sustainable: its yield has increased 6.9% over the past three years and 18.4% over the past five, and the dividend has never been cut. At its May 6 earnings release Digital Realty reported first-quarter funds from operations of $168.1 million, or $1.22 per share, compared to $159.1 million, or $1.16 per share, a year ago in 2013, which was a 5% increase. (Funds from operations is a key figure for evaluating REIT performance.) This result beat the consensus estimate (according to FactSet) of $1.18 per share.