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Q: How did the fund evolve? Could you give us some background information?
The fund was launched in January, 1998. At the time, there was a lot of interest in real estate stocks and REIT funds and Principal had already built expertise in direct real estate investing. In the late 1990s, I was asked to lead an effort to build our expertise in public real estate securities investing. We started with a separately managed account in the beginning of 1997. When Principal launched this fund a year later, our group was selected to be the sub-advisor.
Today the portfolio management team that I lead consists of three people. The team includes portfolio managers Anthony Kenkel and Keith Bokota, who are important contributors to the investment decisions. While I have the ultimate authority on the portfolio holdings, most of our decisions are driven by consensus and are made by the three of us working together.
In 2007 we expanded the size of our team. Today we have five analysts, who support the PMs in finding real estate investment ideas. The people and the consistency of the team have been one of the hallmarks of the fund. I have been with the firm for more than 30 years, managing the fund since inception.
Q: Why do you consider real estate to be an attractive investment opportunity?
In the late 1980s, many real estate investors had grown frustrated with the illiquidity of directly owned real estate as an asset class. Investing in publicly traded real estate companies was viewed to be an attractive substitute to direct investing with superior liquidity.
In the mid-90s, institutional investors increasingly started to allocate a portion of their real estate investment in public real estate companies. Later, the individual investors adopted that same approach and began to have a separate allocation to real estate stocks. The objective was getting exposure to the underlying business of the companies, specifically to the ownership of commercial real estate in the U.S. across a wide range of income-producing properties.
The exposure to income-producing properties through REITs provides the advantage of avoiding double taxation, as long as the REITs meet qualification criteria set by the government. They don’t have to pay any income tax, if they act as a pass-through vehicle and pay nearly all of their earnings to shareholders as ordinary dividend.
By their nature, REITs tend to offer more in terms of income and less in terms of growth compared to other equities. Overall, investors have benefited from a separate allocation to real estate stocks, given strong historical total returns and helpful diversification with the broader equity market.
Q: How do dividend-paying REITs finance their investments?
The requirement to have high payout ratios frequently forces REITs to come back to equity markets when they want to grow. Dependency on public markets for capital creates a healthy discipline for the management. Through stock valuations the market sends management signals regarding growth. When companies trade at premium valuations the market is indicating a willingness to provide equity capital. When companies trade at a discount the market is sending management the opposite signal.
Q: What core principles drive your investment philosophy?
There are two main principles that guide our investment thinking. First, we believe that the performance of real estate stocks is driven by the underlying fundamentals of their businesses. We are fundamental investors and we believe that stocks are ultimately driven by the market expectations for the future fundamentals of the companies and underlying real estate markets.
Second, we believe that the discounted value of the companies’ cash flow prospects is tied to the stock price. The market is efficient in reflecting the consensus expectations for cash flow prospects, but as active investors, we can create value in opportunities, where our views differ from the expectations. We may be slightly more optimistic or pessimistic regarding a company-specific event or we may have a different macro view.
Q: What are the main steps is your investment process? How do you generate ideas?
The majority of our investment ideas come from the bottom-up approach of our forward-looking analysts. Then we narrow down the investment ideas and do in-depth analysis to pick up opportunities. The portfolio management team has a key role in the selection, but it is a bottom-up driven process, where the ideas come from the analysts.
Our analysts follow a three-step process. First, they do an in-depth study on the fundamental characteristics of the company, or a qualitative assessment of the fundamentals. They go through a checklist that includes the quality of the companies’ markets, assets and capital structures. We assess the durability of the income stream, the quality of the management team and its history of capital allocation. Then we make a judgment regarding the strategy for future growth, the alignment of interest with shareholders and the corporate governance. The analysts go through this list of items for each company and produce a report.
The second step is conducting a valuation analysis of the companies. We have built a valuation model that looks at the value of the underlying real estate. Our net asset value model takes into consideration any real estate developments in progress. Then we look at the valuation of the stock relative to its peers and relative to the historic valuations. We examine how these companies trade in relationship to one another over time.
In the third step, we look at the key drivers of future performance. Typically, there are a few aspects that will drive the alpha of the stock. Our team’s responsibility is to identify and study these drivers. Then we decide if our valuation gap is likely to close or not, based on certain characteristics that we see into the future for the particular company.
Our process is fundamental in nature, but we use quantitative models to identify the value of stocks relative to its history and in conjunction with its peers. For example, a company may be trading at a premium to its net asset value, but this premium may be smaller than it had been historically. The premium relative to its peers may be less than its historic values. So, we need to make a qualitative judgment whether the reduced premium creates an opportunity today. As we analyze the changing conditions, we decide whether to step into a stock or not.
Overall, while we have all the models and numbers that indicate value, in the end it is the judgment of our portfolio management team and our analysts that determines whether the flagged company really represents an opportunity today. I believe that our portfolio management team gets these judgments right more often than not, as evident from our track record.
Q: Would you illustrate your research process with some specific examples?
I would use the example of a company, whose primary business owns office property in New York City. Our analysts have spent a lot of time on the company; they’ve met with the management team and know the assets well. The company has been redeveloping properties and taking some of its assets offline. Last year it signaled to the marketplace that the assets will be out of service and the earnings will be depressed. We had avoided the stock after studying it carefully and understanding the business developments.
Meanwhile, as a result of the redevelopment and the depressed earnings, the stock got punished. At that point our analyst was assessing the company’s ability to lease up these assets and the future rental rates. Principal is a significant player in private markets, where we invest in more than 65 U.S. real estate markets with a large team of investors. Within the private real estate group, we have a specialist responsible for New York office space and our analyst worked closely with him on that opportunity.
With the valuable input from the private market expert, our analyst built his valuation model and decided whether we should anticipate better rates and faster leasing than the market expected. Our analyst believed in the opportunity and presented this idea to us after analyzing all the fundamental characteristics of the company and putting together a valuation model.
Q: Could you give another example from a different industry?
I would use the area of retail as an example, not a specific company. One of the problems in retail of late is capital availability to new buyers has been constrained. A year ago, we saw retail stocks, particularly shopping centers, rally on management team indications capital availability was improving. This was encouraging news as additional capital would be beneficial in supporting REIT efforts to sell non-core assets at attractive prices as potential buyers would have access to lower cost debt capital to fund purchases. These indications had lifted the stock price of retail property owners.
We spent time within our large real estate retail group and concluded the market had overreacted. Capital availability wasn't improving as much as had been characterized by management teams. As a result, we resisted the temptation to move into that momentum trade, because we believed that the market had overreacted to these company comments. As 2018 unfolded, our views proved to be correct.
Q: How is your research team organized?
We invest mostly in companies that specialize in a certain property type, so we see benefit in property specialization as opposed to geographic assignments. For example, we have an office specialist, who is responsible for all the U.S. office space companies. Our analyst researches and visits them to get a good understanding of their properties. We do not necessarily need to see every property that every company owns, but we require the analysts to build a good understanding of the property type.
We also leverage the expertise of our private real estate group. In the private area, we have a large team of more than 100 real estate professionals, who know the markets, the companies and the assets quite well. That creates efficiencies and we benefit from our ability to leverage that knowledge.
We believe that the analysts need good understanding of the different types of assets in the various submarkets. Often the companies would show you only the best properties in the best locations and we always look to pierce beyond that, to seek more information and to understand all the assets.
In terms of location, about half of our team is based in Des Moines, Iowa, where the headquarters of Principal Financial Group are. That’s where I am based as well. The other half of our team is based in Chicago. But we work together and communicate with each other daily, so the idea flow works its way up to our portfolio management team.
Q: Who makes the final decision to include a stock in the portfolio?
Ultimately, the fund managers own the investment decisions. The process starts with the analysts conducting their fundamental valuation and presenting it to the leadership team. They have to make a recommendation for every stock in the universe. Then we view the stock and it may lead to a broader discussion and further work. At the end, however, Tony, Keith and I make the investment decisions.
We track the performance of the analysts’ recommendations. Throughout the year, we consistently follow the development of the idea. We track not only how the fund performed, but how each specific recommendation performed. It is also important if it was made at the right time in an accurate and convincing manner. Each analyst also spends time on communicating, filtering and interpreting sector-related news. But the portfolio management team determines what does and what doesn’t go in the portfolio.
Q: What is your portfolio construction process?
As active managers, we want a portfolio that differs from the benchmark. We create a portfolio with high active share ratio in comparison to our peers. A key principle is that our sources of alpha are broadly diversified, so we look for a wide variety of attractive investment ideas with different characteristics. We may own stocks with growth characteristics, but we’ll also have stocks that represent deep value. At different times we’ll have certain tilts, which depend on where we see the most value, but we would still have exposure to different types of stocks. We are very mindful of diversifying the sources of alpha.
Between the risks associated with security selection and allocation, we prefer to take risk in security selection. We view security selection as the most repeatable and reliable form of alpha generation, while sector allocation is a more volatile source of outperformance. We believe that we have an edge in security selection due to the ability to analyze the properties and the companies, to compare them, to identify and overweight the most likely stocks to outperform.
On average, our largest active overweight and underweight are around plus and minus 3% to 4% relative to the benchmark. That’s how we approach portfolio construction. We believe it is the responsibility of the managers to put it together, to consider its risk characteristics and to adjust them.
Q: How do you define and manage risk?
First, there is the risk of absolute loss for our investors. We focus on protecting investors from downside risk, especially in environments where stocks in general are producing negative returns. Since our universe of stocks is relatively narrow, there are times when these stocks are out of favor and losses are difficult to avoid. But it is our job to minimize the downside risk and to protect the investors as best as we can.
Second, we measure risk through our performance relative to a benchmark or to a passive form of investing. Investors are paying us instead of buying an ETF, for example, so they anticipate excess returns relative to a benchmark. When we build the portfolio, we take into consideration the likelihood of the stock to outperform. We believe that our job is to find the stocks that will outperform their peers in the narrow universe. If we pick the stocks that will outperform even in a negative environment, we mitigate the risk of underperforming the benchmark and we protect the investors on the downside.
At the stock level, we think about reward as the forward-looking return potential of a stock relative to its peer group. At the portfolio level, we think about reward as our fund’s excess returns relative to an index or a passive form of investing. It’s important to note that we not only aim for attractive excess returns, but also to deliver them with high level of consistency over time.