2021 is all about stock selection

2020 has been all about beta and understanding how the market trades in and around a pandemic induced recession. For AREITs there were obvious winners and losers from COVID-19. The winners being the Industrial and Logistics sectors, which benefited from the accelerated structural shift of e-commerce. On the other side of the trade, the losers were the large discretionary malls that suffered due to the shutdowns, rent waivers and loss in market share. Then you have the office sector which sits somewhere in the middle in terms of structural shifts (working from home (WFH)) and cyclical impacts (rise in vacancies due to the economic downturn).

With the re-opening of the Australian economy and multiple effective vaccines announced, the recovery trade has led to the outperformance of the COVID-19 “losers” such as Scentre Group (SCG), Unibail Rodamco (URW) and Vicinity Group (VCX) whilst the Covid-19 “winners” such as Goodman Group (GMG) and Charter Hall (CHC) were sold off during November 2020.

So how should investors position their portfolio heading into 2021?

An effective vaccine should reduce the need for more monetary easing and, in this more stable environment, investment performance will be more about stock picking (alpha) and should favour those securities that can deliver earnings growth.

In our view, the new normal for REITs will have to take account of structural shifts that were already being played out even before COVID-19, such as growth in e-commerce and flexible working arrangements, which continue to be headwinds for discretionary retail malls and some office assets.

In order to assess earnings growth there are 3 key factors that we consider:

1. Positive free cashflow
2. Strong balance sheet
3. Sustainable earnings through favourable thematics or long WALE (Weighted Average Lease Expiries)

With this in mind, our conviction on logistics - Goodman Group (GMG), and data centres - Next DC (NXT), is even higher now post the COVID-19 recovery trade.

The reopening of the economy, helped by a potential vaccine, will see a pause in e-commerce growth but it will accelerate again as people adopt the convenience of e-commerce and companies embrace flexible working arrangements (WFH one to two days a week).

Both GMG and NXT are leaders in their markets. In GMG’s 1Q21 update, the group reiterated their FY21 operational earnings growth guidance of +9%, whilst their development pipeline (work in progress) is ahead of near term estimates of $7.3 billion, further validating the demand for these assets over the medium term. NXT is similar with FY21 guidance reconfirmed at their AGM for data centre services revenue growth up 21% - 25% on FY20, driven by strong growth in recurring revenue underpinned by long term contracts and over 17MW of contracted capacity yet to commence billing. With the expansion of their second generation centres (S2 and M2) and third generation centres (S3 and M3) capacity is estimated to increase to 176MW (2.5 times growth) in the next 5 years to accommodate the strong demand from hyper-scalers (Google, Amazon, Microsoft, Netflix, Facebook etc) and enterprises adopting the cloud.

On the flip side, we see continued downside risk to discretionary malls’ earnings even in a post COVID-19 world where foot traffic has recovered 80-90%.

The structural shift to online retailing warrants these malls trading at discounts to their NTAs. Traditionally, large grocery chains have been anchors for retail malls to attract traffic to specialty stores. With COVID-19 accelerating the shift to online sales, we’ve seen Coles reporting online sales growth of 57% and Woolies 100% during September 2020 quarter. Both Coles and Woolworths have been heavily investing in capability and capacity to deliver a long-term growth strategy of providing a better online experience. Anecdotal evidence has shown that specialty sales for retail malls are still flat compared to online retail sales (ex food) which remain strong on average +20% p.a.

The last six months have created a lot of volatility that has, however, also created a lot of opportunities and accelerated a number of secular trends that benefit non-traditional property sectors. Being able to invest outside the benchmark into new growth sectors driven by these trends such as data centres, logistics, childcare, seniors living and affordable housing not only provides diversification away from core sectors such as retail, office and industrial but provides more sustainable earnings growth.