Ask Rick Buoncore of MAI Capital Management to predict how the stock market will perform next year, and he will trot out a quote by one of his favorite thought leaders, renowned investor Howard Marks: “You can’t predict. You can prepare.”
To Buoncore and his colleagues at MAI Capital Management, the “Marksism” is more than a talking point. It’s an idea that’s deeply ingrained at the fee-based wealth management firm — where investment professionals regularly survey the investment universe and determine where clients are likely to get the best risk-adjusted returns that are aligned with their goals and objectives over the next five to 10 years.
Today, the consensus at MAI Capital Management is the universe is shifting in ways that make real assets compelling, although investors must be highly selective.
DIVERSIFICATION MATTERS
In what ways are the stars realigning? For starters, Buoncore and his colleagues believe that stock market returns will be more modest in the near term and volatility will likely increase. They expect the market to return roughly 5 percent to 6 percent per year over the next five years. That is a far cry from the returns for 2016 and 2017, when the S&P 500 gained nearly 12 percent and 22 percent, respectively.
“The stock market’s been on a 10-year run and, while it may not be overvalued, it’s certainly at best fairly valued,” says Buoncore, managing partner of MAI Capital Management. “We still have to be there, but on the fringe, we’d rather allocate to things we think are very good, solid investments with less risk and equal or better returns.”
Buoncore and others are even more concerned about the bond market outlook in light of the fact that the Federal Reserve is likely to continue to raise short-term rates to keep inflation in check and give itself ammunition to fight the next recession. At the same time, the Fed is draining liquidity from the fixed-income market as it pursues quantitative tightening — or the unwinding of the extraordinary quantitative easing stimulus program it implemented during the financial crisis.
“The Fed will continue to raise rates to normalize our situation,” says Buoncore, noting that interest rates remain low by historical standards. As a result, “you have to expect that the best you’re going to get [in the fixed-income markets] is the coupon. Returns don’t seem particularly exciting there as well.”
A couple years ago, the search for yield led MAI Capital Management to begin investing on behalf of some high-net-worth clients in triple-net-lease commercial properties with investment-grade tenants. It is still bullish on the niche.
The investments — which have generated a yearly cash return of about 8 percent — are sourced by a firm specializing in negotiating sale-leaseback deals with investment-grade companies (think leading insurers, healthcare companies and banks). The sale-leaseback deals allow the companies to covert a portion of their value (i.e., real estate assets) into useable cash, typically to reinvest in themselves.
Under triple-net leases, tenants are responsible for taxes, insurance and maintenance costs, and “the rent check you collect as a landlord is your net operating income,” explained Kurt Nye, a managing director at MAI Capital Management. The investments, he notes, have generated a nice spread (some 400 basis points) over comparable high-quality corporate bonds.
“Not every client can have that much illiquidity in their portfolio, but, if you can afford it, the risk-reward opportunity is tremendous,” says Buoncore, adding the investments also have nice tax advantages.
AN INFLATION HEDGE
Investors are also taking a fresh look at real assets in light of the prospect that inflation is heating up. Infrastructure — such as toll roads, utilities and cell phone towers — is often seen as an inflation hedge for several reasons. Certain assets have monopolistic pricing power within their markets, making it easier for them to raise rents, or charge higher prices, to adjust for inflation. And, very often, they have long-term contractual agreements that call for regular rent bumps, or permit them to raise rents or prices when the Consumer Price Index ticks higher.
The CPI rose 2.3 percent for the 12-month period ending in September 2018. The core CPI, which excludes volatile food and energy components, rose 2.2 percent for the 12 months ending last September.
“Real assets look to be in a pretty good position for the simple reason that over the last 15 years, there has been a fight over whether we would wind up in an inflationary or deflationary environment,” says Bob Rice, founder and managing partner of Tangent Capital Partners, as well as the firm’s consulting affiliate, Rice Partners. “It looks like we know which way the wind is blowing right now.”
The soaring federal deficit is exacerbating inflation-related worries. The deficit rose to $779 billion in fiscal 2018, up from $666 billion the prior year, and it is only expected to widen in future years. Deficits can drive up inflation if they are accommodated by monetary policy, meaning that the Fed responds by increasing the growth of money, according to the Federal Reserve Bank of St. Louis.
“I’m not some great predictor of anything. Nobody is,” says Rice. “But you can handicap risks and adjust your portfolio accordingly. If you are not taking into account as realistic the risk of deficits harming our economy and driving inflation, you’re just being silly.”
BREAKING FROM THE HERD
Rice also argues that investors also need to think more about downside protection. Diversifying between stocks and bonds might not be enough, he said, adding that, contrary to popular belief, they tend to move in the same direction over long periods of time.
The last 15 to 20 years have been an anomaly, he said. If you look back over the past century, you will see, according to Rice, that stocks and bonds have typically moved in the same direction. This year, investors got a taste of what Rice calls the traditional relationship between stocks and bonds. For many — particularly those with a passive portfolio construction — the results were not pretty, he says.
“We’ve seen situations where stocks have had powerful downside volatility, but the bond market has not come to the rescue,” Rice notes.
Melissa Reagan, TH Real Estate’s head of research for the Americas region, an affiliate of Nuveen, says market volatility — combined with strong economic growth and concerns about inflation — bodes well for investor demand for real assets, especially on the private side. The Trump administration’s tariffs, rising wages and higher levels of government spending are among the reasons many investors are concerned about inflation, she notes.
“People will see real assets as a place to put more capital,” she said, pointing out that the U.S. economy should continue to benefit from the stimulus effects of tax cuts and higher levels of government spending into next year and possibly 2020.
“As long as the economy hums along, real assets should continue to hum along with it,” says Reagan.
THE VALUATION CONUNDRUM
Yet, when investors look to real assets, many are concerned about high, late-cycle prices, particularly in the real estate and infrastructure sectors, says Reagan. On the whole, fundamentals are still strong, she says. But prices have been rising for nearly a decade.
“At this point, investors are concerned about valuations being high,” she says. “From a real estate perspective, there are pockets of imbalance here and there, such as for luxury apartments. But by and large, there isn’t a great deal of concern among investors about underlying fundamentals.”
High valuations make it difficult for would-be investors to extract additional value by repositioning assets or investing capital to generate organic growth, says Andrew Deihl, Nuveen’s head of energy and infrastructure, private markets.
The combination of high prices and rising rates has already changed the calculus for many large investors, he noted. “As debt becomes more expensive, it becomes increasingly challenging to pay these heady prices,” says Deihl.
Institutional investors are pursuing what Deihl calls a bifurcated strategy. Those with a high hurdle rate, or relatively high cost of capital, are taking on a bit more risk by acquiring assets that “are less core in nature,” he says. Others, such as pension funds, are beginning to accept potentially lower returns for “more-core” assets that tend to be resilient through multiple economic cycles.
“One of the historic rationales for investing in infrastructure is that it’s uncorrelated to the broader equity markets,” explains Deihl. “If you stay core, that’s still true today. But to the extent that you are doing a lot of core-plus or value-add, you are introducing a fair amount of beta risk that is a challenge to manage in a multi-asset portfolio, especially if you hold a lot of stocks and bonds,” he cautions.
THE LONG ROAD
Indeed, as they look across the late-cycle universe, many investors favor real assets that are expected to benefit from longer-term trends, such as the apartment and industrial sectors.
The apartment sector has seen a great deal of development in recent years, but demand continues to outstrip supply in many markets, and home affordability remains an issue for many would-be buyers, particularly middle-income Americans, says Reagan of TH Real Estate.
Strong market conditions contributed to a 6 percent increase in multifamily lending during 2017, as lenders provided a record $285 billion in new mortgages for apartment buildings with five or more units, according to the Mortgage Bankers Association’s 2018 annual report on the multifamily lending market.
Meanwhile, industrial properties, particularly light-industrial buildings near cites, are benefitting from the rise of e-commerce, including online sales by traditional retailers.
“Retailers are expanding their e-commerce platforms, and we don’t see that trend going away anytime soon,” says Reagan.
BACK TO THE FUTURE
For its part, MAI Capital Management remains bullish on energy-oriented master limited partnerships (MLPs), specifically midstream pipeline operators that are often described as toll-road-like businesses. The publicly traded MLPs generate revenue by collecting fees for moving, storing or processing energy. The volume of traffic, rather than the price of the material transported, determines how much revenue they collect.
Midstream MLPs give investors exposure to what has been dubbed one of the most-attractive secular growth stories in North America, the revolution in production techniques that made the United States the world’s largest producer of oil and natural gas.
MAI began investing in midstream MLPs on behalf of some clients nearly 10 years ago, and its instincts proved right. The U.S. oil and natural gas markets subsequently took off, as did the growth and valuations of midstream MLPs.
“We saw a business that owned very stable, cashflow-producing assets that also distributed a large majority of income to shareholders on a yearly basis and had steady growth, both from the inflation escalators built into pipeline contracts and the growth of the U.S. natural gas and oil markets,” says John Zaller, the firm’s CIO.
Then came the oil crisis of 2015, caused by a global, crude oil glut that pushed prices down to levels not seen since the financial crisis. Technological advances in drilling and Saudi Arabia’s refusal to cut production as prices fell contributed to the glut.
In response to the crisis, many midstream MLPs restructured their businesses and cut their growth rates and dividends. Their balance sheets and fundamentals have improved dramatically over the past couple years, but their stock prices have not kept pace, says Zaller. Oil and natural gas prices have trended upward since 2016, although oil fell back into bear-market territory earlier this year.
“Going forward, it feels like we are back to the environment we identified when we initially invested in the space,” says Zaller. “You have stable, cashflow-producing assets with probably more-modest growth than had been expected in 2013 or 2014, but still pretty steady growth.”
With the yield on Alerian MLP Index at slightly more than 8 percent (as of early November), the midstream MLP space, he said, represents an “attractive total-return opportunity” tied to the country’s dominance of the global energy markets.
What about the looming threat posed by the proliferation of electric cars, which is expected to reduce worldwide oil demand? Zaller and his colleagues think it is too soon to write the oil industry’s obituary. They argue that breakthroughs in electric-vehicle battery technology are likely to be slower than many others anticipate.
“The whole question is how much power batteries can store,” says Buoncore. “There has been major movement on that, but not anywhere close to what’s needed to take a car from Portland [Ore.] to Cleveland without worrying about recharging.”
For the next several years, at least, MAI Capital Management and other advisers will be looking to midstream MLPs and other real assets to provide downside protection and enhanced returns in a shifting investment universe.
Anna Robaton is a freelance business journalist based in Portland, Ore.