Keep Calm and Buy – Data Center Stocks are On Sale

DCK Investor Edge is a weekly column about investment in the data center market, covering both publicly traded data center REITs and privately held players in the space. More about the column and its author here.

"They kilt us, but they ain't whooped us yet." – William Faulkner

Everyone loves a bargain. However, one of the most difficult things for investors is pulling the trigger to buy quality companies when prices decline sharply in the middle of a global equity meltdown. Most retail investors are asking: Where is the bottom? Will this selling ever end?

Perhaps more useful questions for long-term investors might be: Has the thesis changed for owning shares in a publicly traded company? If not, is the price now attractive vs anticipated earnings growth?

Unfortunately, an indiscriminate Wall Street selloff is an exogenous risk that rears its ugly head from time to time. And it’s hard to buy – even if you know it is the right thing to do.

"Fear Index" a Record Spike

While it might sound like something out of a Stephen King novel, you really can trade in a barometer measuring fear on Wall Street. The CBOE Volatility Index, commonly known as VIX, is a bet on expectations for future price swings. Normally, the fear comes in when equity markets unexpectedly swing -- especially when they swing violently down.

During 2017, there just wasn’t much volatility. Week in and week out, the broader stock market set multiple records. Greed was the dominant force. Investing was a no-brainer, and the main fear was FOMO on the record gains. There was minimal angst that stock valuations would suddenly spike down and wipe them out.

On Monday, that all changed. The VIX spiked from an already elevated 25 reading on Friday to almost 50 in one day, an all-time record. Trading was halted Tuesday morning on many inverse VIX ETFs, which placed levered bets making easy money when markets were calm for months and were suddenly wiped out by the price swings.

These types of leveraged bets are often made by sophisticated hedge funds and traders, and some of these professionals got caught with their hand in the cookie jar. Meanwhile, most retail investors are more concerned with sudden paper losses in retirement accounts and brokerage statements.

Déjà Vu?

It is normal and healthy for overbought markets to correct. Often the best time to buy is when there is proverbial "blood in the streets." However, on a psychological level, nobody is comfortable watching retirement savings shrink.

It is also natural for investors to want a logical reason to understand why Mr. Market has suddenly changed course. Some widely reported explanations for the sell-off include: 1) a fear of rising inflation in the US economy; 2) a steep rise in borrowing by the US Treasury to make up for lost revenues from the lower corporate tax rates; and 3) a spike in the import of foreign goods causing a large trade imbalance.

Any or all of these factors could lead to a more hawkish Federal Reserve under policies set by the new Fed chairman Jerome Powell, who took over from Janet Yellen Monday.

S&P 500 heat map for week, Feb.5, 2018

But the truth is we can never really know why these events occur, as there are too many variables to consider.

"History Doesn't Repeat Itself, But It Often Rhymes"

Wall Street investors haven't seen a global sell-off like this since the "China Syndrome" sent stocks tumbling in January 2016, and Brexit roiled the markets that summer.  

In Q1 2016, concerns about China's slowing economy, depressed commodity pricing, and an energy sector reeling from a global oil and gas oversupply dominated the headlines. However, data center REITs proved to be a safe haven for investors who held onto their shares.

But things are different this time when it comes to REITs in general and data center stocks in particular.

Data Center Buying Opportunity

The broad selloff in US equities this past Friday and Monday erased January’s sizeable gains enjoyed by the DOW 30 and S&P 500. Both indices had been setting records on an almost daily basis. Real estate investment trusts, however, had not participated in the gains.

Prior concerns regarding three potential interest rate hikes this year had already driven down publicly traded REIT prices -- before the last few days of frenetic selling. The Vanguard REIT Index ETF (VNQ) lost 9.83 percent as of February 5, 2018. And this time, data center REITs did not escape the carnage.

Two years ago, investors could do well just holding onto data center REIT shares in the face of a global equity selloff. The data center REIT sector was outperforming both the broader REIT and S&P 500 indices. There was no need to buy more shares in 2016.

As of Tuesday afternoon, the five data center REITs: CoreSite Realty, CyrusOne, Digital Realty, Equinix, and QTS Realty (not market-cap weighted) were down an average of -8.75 percent. If you add the newly public Switch to the mix, the performance on average drops down to -10.1 percent. (Although Switch is not a REIT.)

This selloff has created an opportunity to initiate a position in these data center REITs or add to existing holdings. The way to take advantage in 2018 is to buy at these lower valuations.

Investor Edge

According to the recent Jones Lang LaSalle 2018 Data Center Outlook, net absorption in top data center markets was solid in 2017. Supply and demand fundamentals in most of the larger data center markets seems to be within normal ranges, with a notable exception of Toronto, where existing inventory and active development is significantly greater than historical leasing.

The demand drivers in 2018 are similar to last year’s: cloud computing and hyper-scale leasing, hybrid IT deployments, streaming video, SaaS deployments, big data/AI, virtual reality, Internet of Things (IoT), content distribution, enterprise sale/leasebacks, and enterprises needing secure, low-latency connectivity to multiple public cloud providers, employees, customers and vendors. There is no reason to believe these secular trends, which have provided a tailwind for the data center sector since Q4 2015, will show signs of evaporating into thin air.

Today, CoreSite Realty will be the first data center REIT to report Q4 and FY 2017 results. A solid earnings print and initial outlook from CoreSite could become the catalyst for data center stocks to begin to reverse the current selloff, regain lost ground, and signal the next leg-up for prices. Why is this likely to happen? During the past three-year and five-year period, CoreSite has been the top REIT for total return across all REIT sectors.

CoreSite's connectivity-focused retail colocation business model generates predictable earnings growth, where most new leases signed are expansions where existing customers require space, power, and additional cross-connects. The earnings growth is so predictable that the CoreSite board now evaluates the quarterly dividend distribution twice a year.

After the recent selloff, the likelihood of data center outperformance in 2018 is much higher.