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Boring Is Beautiful

I was recently asked to speak about investing to a group of undergraduate students at the University of Florida who manage a university student fund. I was initially stumped regarding what we would discuss, but upon speaking with one of the students, it became clear they were eager to discuss a real-world example in relation to our approach to investment research.   

What I love about talking to students is their eagerness to learn and ask excellent questions. They often want to find “the next great investment”. This often leads them to search areas having fast growth and exciting new technologies, yet frequently dubious economics and durability. Voila!! I had my idea!

Years ago, our investment team met with legendary Texas Instruments (TI) CEO Rich Templeton, and he was explaining why TI had exited the fast-growing mobile chips business. He explained “sure, mobile is exciting, but car accidents are exciting too!” Rich was no fool, and he knew falling prices, high capital intensity and customer concentration were no reason to be in an “exciting business”. There are cases where exciting is good, but those of us who have been in the investing business a long time know “there are no style points in investing”. Boring is sufficient, and often, boring is beautiful!  

So, I set about preparing my presentation, fully prepared for the entire class to be asleep by the end. I shared with them an interesting case study on PS Business Parks (PSB), an industrial and flex/office REIT (real estate investment trust). It doesn’t take a 180 IQ to recognize real estate isn’t an exciting business. However, when judging by the company’s track record of compounding value for shareholders at 14% per year from 2000 until 2019, while using far less leverage than the industry, I would call that exciting!

How did PSB pull off such a feat? The way we see it, there are four elements to PSB’s success:

1. PSB operates its assets with a smaller tenant base, which leads to higher revenue per foot than peers ($14 per square foot vs. peers’ ~$9 per square foot). Clearly, earning more revenue per foot on a building that costs a similar amount for an owner to operate is a differentiated approach.
2. PSB chooses its markets carefully and then concentrates in those markets. Wise market selection results in operating in areas with more growth and higher barriers to entry, which leads to more pricing power over a market cycle. Then by concentrating in a few markets, PSB gains enough scale to operate efficiently with a more operationally intensive customer mix.
3. PSB hires selectively, seeking motivated individuals who can handle high levels of autonomy. By providing autonomy to motivated and capable employees, they are empowered to execute a strategy focused on operating efficiently at scale even with a turnover-prone tenant base.
4. By focusing on maintaining the company’s financial strength, PSB can better protect the business in an economic downturn and position itself for the potential opportunity to buy assets at discounted valuations.

It needs to be noted that no strategy is without flaws or risk. The downsides to PSB’s strategy are with smaller customers, operational intensity is increased, credit risk is higher, shorter terms on leases cut revenue faster during economic contractions, and downturns are potentially more severe.

As value investors, we had long admired PSB’s model, but so had the market, and shares were often valued aggressively. But then in the fall of 2020, PSB came under pressure as market participants came to realize COVID-19 was unlikely to disappear and a contraction in economic activity was probable. PSB’s customer base focusing on SMBs (small and midsized businesses) would be hit first. With business formation falling, leading to oversupply conditions, rents were likely to be pushed lower. Additionally, PSB’s development pipeline increases risk during market downturns. While analyst coverage was minimal, many of those who did cover the name were negative on the company due to earnings likely to come under pressure in the near term.

In the real estate business, financial flexibility is an asset. This “asset” isn’t carried on the books, but it provides the business strategic advantages in a potential downturn. First, the company reduces the need to incur expensive debt to support the business, and second, it may be able to deploy its capital to buy assets at attractive valuations in order to further build future earnings power. In late 2020, PSB had no debt outstanding. The capital structure was comprised of equity and preferred stock. While the preferred stock is a form of leverage, it has no maturity date, no covenants, and is interest only. Counting the preferred stock as debt, leverage in late 2020 was 3.2X debt-to-EBITDA. The average REIT runs in the range of 5X-7X debt-to EBITDA.

Exhibit 1: PS Business Parks—Debt to EBITDA (Millions)

Source: Company financials. Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) is an indicator of a company's financial performance which is calculated by looking at earnings before the deduction of interest expenses, taxes, depreciation and amortization.

As well, the fixed charge coverage ratio (FCCR) was over 5X, which is also best in class for a REIT. The FCCR indicates a firm's ability to satisfy fixed financing expenses, such as interest and leases. Lastly, financial flexibility was preserved by PSB’s board having a policy of always paying out the minimum legally required dividend to retain REIT status.

So, in 2020, while the markets were in retreat and investors were fearful of PSB’s likely earnings contraction, what we saw was a superior real estate operator, with a protective balance sheet, trading at a rare discount using a variety of valuation techniques. We too knew PSB’s business was likely going to be challenged for some time, but we also believed, using a longer-term lens, economic activity would recover. Like many stocks, PSB recovered over the following year as pandemic uncertainty waned and investors rewarded strong execution and continued free cash flow generation. Then, in 2022, the company was taken out by Blackstone, the world’s largest real estate investor. PSB wasn’t a glamour stock, but it didn’t need to be. Investing involves doing the necessary research to assess the business, management and company financials. If you do this work, you’re then in a position to identify opportunities when good businesses with sound financial conditions are selling at attractive valuations. Boring isn’t so bad!

Exhibit 2: PS Business Parks—Price Chart

Source: Bloomberg. 1 Jan 2019–19 Jul 2022. Past performance does not guarantee and is not a reliable indicator of future results.