Publications

- October 1, 2020: Vol. 7, Number 9

New investing themes for a new decade

by Mike Consol and contributing executives

Urbanization, demographics, technology — these are some of the repeated mantras used by thematic investors for many years running, even as the U.S. and global economies have undergone a metamorphosis worthy of a Kafka novel. Yet, investment strategists seem to keep repeating the same, old, tired set of “themes” to guide their asset selection.

Might there be a new set of investment themes for the new decade? Might new themes include blockchain, cryptocurrencies, autonomous transportation and artificial intelligence? Clearly, the plot has thickened, and perhaps even reversed course in the case of urbanization. A couple of researchers recently told Real Assets Adviser we have entered a new phase of de-urbanization. Another analyst, Renato Leggi of ARK Invest, makes the argument that disruptive technologies are an emerging sub-asset, that a diversified basket of innovation stocks has the potential to enhance risk-adjusted returns in global equity portfolios.

We turned to some of the many experts in the private and institutional wealth space and asked them to identify new thematic investing strategies that could help carry portfolios through what has certainly started off as a challenging decade.

 

THE DIGITAL SUPPLY CHAIN

Melissa Reagen, head of Americas research, Nuveen Real Estate

With internet traffic surging — and COVID-19 making life in the digital world increasingly meaningful — the assets forming the digital-data “supply chain” now represent an appealing opportunity for private investors in alternative real estate.

The asset group includes data centers of many sizes housing critical IT infrastructure for corporations, governments and consumers, as well as cell towers providing wireless service in rural and urban areas, alike.

While the majority of the data-center and cell-tower markets are owned by publicly traded REITs, the sectors have promising secular tailwinds and offer potential opportunity for generating alpha in private real estate portfolios. Since launching, REITs focused on these assets have generated significantly higher returns than those of traditional REITs.

Longer-term structural trends in data transmission should continue to spur demand for these assets. Among the positive forces are the growth of global internet traffic, expanding mobile-to-mobile connections, and “next generation” innovation, from artificial intelligence to the internet-of-things.

The COVID-19 era’s realities also should provide a boost. Data-center usage has increased throughout the pandemic, as most of the global workforce needed to work from home. In a post-COVID environment, large corporations will look to modify and improve their IT infrastructure as more of their employees work remotely, and will look to outsource their data-storage capabilities to data centers to save on cost. Importantly, both sectors were enjoying significant tailwinds even before the pandemic, with both developed and developing countries constructing new IT infrastructure to speed the transmission of online and mobile data.

Providing strong risk-adjusted returns during volatility — and a likely buffer against COVID-19’s impact — both sectors merit a careful look from investors eager to build additional, beneficial diversification into traditional real estate portfolios.

 

RE-SHORING U.S. MEDICAL SUPPLY CHAINS

Joe Zidle, chief investment strategist, Blackstone

COVID-19 is accelerating several trends such as increased ecommerce penetration, migration from the North and Midwest regions to the South and West, and the movement of supply chains. The virus has also uncovered a critical weakness in the U.S. medical supply chain. It’s my view this will result in a secular investment opportunity and strengthen the country’s ability to respond to future health emergencies.

Important parts of the U.S. medical supply chain could be re-shored. Labor and other cost advantages drove manufacturing out of the United States, and I expect focused policy efforts to incentivize companies to reconfigure supply chains and balance efficiency with resiliency.

The White House and Washington policymakers are intensifying their focus on mitigating medical supply-chain risks. The President has already signed two executive orders involving the Defense Production Act and the International Development Finance Corp. that relate to the strategic production of resources. Policy analysts believe additional administrative action is being considered that would allow the FDA to speed up its approval processes and further facilitate onshoring. On the congressional side, more than 20 bills have been introduced in the Senate and House to address potential risks in the U.S. supply chain.

Shifting supply chains back to the United States is a monumental task. For example, industry groups estimate that building a generic-drug manufacturing facility can take five to seven years and cost up to $1 billion. Factories also require large footprints and, preferably, low-cost labor, as well as guidance on environmental regulations that govern the handling and disposing of toxic chemicals. It can be done, of course. In the 1970s, Congress passed tax breaks that turned Puerto Rico into a primary manufacturer of U.S. drugs, which lasted until the mid-1990s, when the benefits were eliminated.

But there is only so far private companies will go without government leadership; otherwise, they risk trying to push through higher prices. Onshoring will take a concerted government effort. Tax and investment structures will be critically important in minimizing the effect on prices paid by consumers and healthcare providers. For example, under a plan proposed by generic-drug manufacturers, Health and Human Services (HHS) would issue guaranteed long-term price and volume contracts for certain high-priority medicines. The plan would also give HHS the power to issue grants to support the construction of facilities, establish tax incentives and facilitate regulatory efficiencies.

The addressable market for the U.S. medical supply chain consists of several opportunities. Imports to the United States for medical devices alone are forecast to exceed $106 billion by 2023, while the U.S. already imports more than $132 billion per year in pharmaceutical products. Logistics, construction and new jobs also stand to gain as the critically important supply chain is reimagined here in the United States.

 

CLIMATE CHANGE RESILIENCE

Ashby Monk, executive and research director, Stanford Global Projects Center

Real estate investors around the world are coming to the same realization: They can no longer ignore climate change in their investment decisions. Traditionally, climate change did not receive the same attention as other catastrophic investment risks because it was seen as “nonfinancial.” And when it was considered, it was an afterthought, a box to tick rather than a real factor in an investment decision.

But the fires, storms and other climate catastrophes in the past few years have woken investors to the possibility, and indeed reality, that their portfolios are vulnerable to repricing. And, thanks to alternative environmental data and novel analytic techniques, they can now put investment logic to this realization. Climate change is being transformed from a purely scientific discussion about the environment into an investment and business discussion about how to manage climate risk in dollars-and-cents terms.

Scientists have already developed probabilistic climate risks based on the latest research, which are being combined with unique property-level data in order to project hazards and damages related to climate change. These insights are now being translated by financial economists into probabilities of default, loss given default, and even prepayment. As such, this financialization of climate is now forcing investors to reconcile with the long-term consequences of floods, rising sea levels, hurricanes, extreme winds, extreme temperatures, landslides, rain, snow, hail, drought and wildfires.

Significantly, these new analytics will power new strategies and products that will bring climate change into the real estate investor’s toolkit. More to the point, some investors will seek to actively manage their climate risk to outperform relative to those investors who are not integrating climate risks. I have already seen climate-related analytic tools that directly inform and improve valuation models for an individual mortgage or a bond.

In sum, by bringing together the latest in climate science, economic research and financial analysis — all the while underpinned by new big-data techniques — we are finally solving the “last mile” problem for real estate investors as it pertains to climate risks; we can actually integrate it into an investment decision. As such, we can now deliver climate-related, investible insights to real estate investors, which will transform how we assess, invest, manage and sell real estate over the long term.

 

AUTONOMOUS VEHICLES

Sam Bendix, managing director, investor relations, National Real Estate Advisors

Like the railroad and the original automobile, autonomous cars have the potential to expand our suburban frontiers, disrupt urban transit and reshape much of the built environment.

Today’s cars are burdened with flaws that can be solved with autonomous technology. While commercials show cars owning the open road, most cars are used for tedious and long commutes in congested traffic. On top of that, the typical car sits idle 95 percent of the time in parking lots and driveways, deteriorating and losing value. Edmunds notes that a new car loses about 20 percent of its value in the first year and by the fourth year, half the value is gone, which is entirely unappealing to everyone, but particularly to “asset light” millennials. Moreover, while COVID-19 looms large today, according to the World Health Organization, road traffic crashes were the eighth leading cause of death worldwide in 2016, resulting in 1.8 million deaths, and the National Highway Traffic Safety Administration attributes 94 percent of serious crashes in the United States to an individual’s choices.

In a world where autonomous cars are widespread, the promised ability to summon a car on demand from companies like Lyft and Uber — even outside of urban and suburban areas — would likely be more convenient and cheaper than owning a car. These cars would allow their occupants to socialize, work or scroll through their phones to their hearts’ content, making long commutes feel shorter. More importantly, driverless cars don’t sneeze, text, drink or fall asleep like their human counterparts.

As driverless cars become a larger presence in everyday life, and their advantages become evident to consumers, businesses and governments, their adoption will be rapid. So, what does this mean for commercial real estate? As with the adoption of railroads and driven automobiles, urban cores will remain the central gathering spaces for vast metro areas, but the suburbs will expand. The need for consumer parking, whether in expensive urban underground garages or in vast lots surrounding shopping malls, will diminish along with car ownership. The fall in development costs could increase developer profits and drive lower rents as the available space is redeveloped into more office and residential buildings, or reimagined as inventory storage for last-mile delivery.

The impact of driverless cars could be felt as much in the virtual world as in the built environment. The safety and reliability promised by driverless cars hinge on a vast array of sensors generating prodigious amounts of data. Each driverless car is expected to produce a petabyte of data per year through its array of cameras and radar sensors. This means 2 million driverless cars on the road producing as much data as traverses the entire internet today. This new data will be processed, stored and analyzed, resulting in significant demand for data-center space by car companies and the like.

 

FINANCIAL MARKETS INFRASTRUCTURE AS A SERVICE

Jackson Mueller, director of policy and government relations, Securrency

Financial-technology players are rapidly developing innovative solutions capable of supporting the movement of digitized or tokenized assets across legacy and new blockchain-based infrastructure that automatically responds and adheres to regulatory requirements across jurisdictions. In doing so, these providers have effectively built on-ramps to an integrated ecosystem in which legacy systems and processes are interoperable with these innovative, more-efficient networks for transacting assets. In a phrase, what is being developed is financial markets infrastructure as a service, and the purveyors of these new technologies have laid the rails that unlock accessibility, provide institutions with significant scaling opportunities, and support the global adoption of distributed ledger technology in financial services.

The movement of digital assets between and among blockchain networks and legacy infrastructures has been — and is still — hampered by the lack of interoperability, siloed systems that do not talk to one another, and the continued impulse on the part of technologists to favor one ledger or technology over another. These challenges perpetuate a financial-markets ecosystem that remains inefficient, costly and, where legacy systems are involved, increasingly stressed as preferences shift from analog processes to the digital movement of value.

Similarly, this movement of value from analog to digital and across jurisdictions faces significant headwinds, given differing regulatory treatments applied to different types of assets and mounting scrutiny over Know Your Customer and Know Your Business compliance processes.

Simply put, there is a need for infrastructure providers that are capable of addressing these challenges in a holistic way by providing financial firms with intuitive interfaces connecting to platforms with the appropriate tools for bridging disparate systems, while ensuring firms remain compliant with ever-evolving regulatory requirements. In doing so, these new platforms are creating or supporting the development of global, liquid, digital asset markets.

The challenge, of course, is the direction governments decide to take. Will it be an open framework of interconnected ledgers operating in a decentralized environment that provides optionality and choice? Or will it be a monolithic, centralized framework that could significantly threaten the privacy of transactions, and impair access to the platforms and the free flow of digital forms of value?

Given the tools of interoperability and compliance, financial institutions can offer a whole suite of investment services in digital form to a wider array of customers across a wider array of financial systems and jurisdictions.

 

ESG FOR INVESTMENT RESILIENCE

Linda Zhang, CEO, Purview Investments

In the disheartening aftermath of the global pandemic, one may assume a diminishing interest in ESG-aligned investing. On the contrary, investing based on the environmental, social and governance (ESG) principles has been embraced with strong asset growth and performance resilience. In the exchange-traded-fund industry, ESG ETFs doubled their assets under management in the first seven months, versus a 5.8 percent growth for the industry.

The pandemic has pushed ESG issues to the forefront. The environmentally damaging oil and coal industries experienced a demand destruction. Carbon-intense airlines and cruise lines struggled to survive as travel came to a halt. Furthermore, investors care about how firms handled employee safety, job security, and more equitable and inclusive growth. Those who failed suffered from customer backlash and lost revenues.

The pandemic also spotlighted investment themes stemming from ESG-aligned industry transitions toward a decarbonized, ESG-consistent economy. The pandemic only accelerated these shifts, creating enduring investment opportunities beyond the pandemic era.

The energy industry transition, from fossil fuels to cleaner solar, wind and other alternatives, is likely to be expedited. Oil and coal companies are facing multiple hurdles from declining demand [and] investor backlash to high regulatory risks, stranded-asset risk and the risk of share mispricing. Several major banks’ recent announcements to cut ties with the fossil fuel industry will further raise the cost of capital. Globally, alternative-energy adoption is rapidly rising, with ever-competitive pricing and supportive policies. Investors can choose from solar- and wind-focused ETFs or broad-based clean-energy ETFs.

The transportation industry has been experiencing three stages of revolution: electrification, ride-sharing and autonomous driving. Transitions to green transportation dramatically reduce carbon emissions. Companies that are early adopters and leaders in these transitions are likely to win in the long run. Investors can research thematic ETFs that focus on AI and automation, car batteries and materials.

The global pandemic has expedited a shift in corporate culture to flexible work hours. In fact, Twitter and Square announced a permanent work-from-home policy. This is consistent with trends toward reimagining work/life balance, operational efficiency, reduced carbon footprint from smaller offices, less road congestion and less pollution. Companies providing work-from-home enabling technologies will benefit. Look for work-from-home themed ETFs that invest in the enabling-technology firms.

The global pandemic forced the adoption of online purchases instead of in-store. The habitual practice of ordering goods online, streaming movies, playing esports, cycling at home will persist beyond the pandemic. Leaders in online presence will likely benefit in the long run. Investigate ecommerce-focused thematic ETFs, including those exposed to emerging markets with a vast and rising market for ecommerce and digital entertainment.

The pandemic has accelerated business transitions more consistent with climate resilience and inclusive growth. Investors must adapt their investments to embrace champions in these transitions.

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