Next DC – A share price ‘infected with enthusiasm’

Since the late October 2023 low, the S&P500 is up around 27%. The NASDAQ100 is up 30%. In Australia, the ASX200 has advanced around 16%, but at a sector level, there is a wide variation of returns.

The resource sector has weighed on the overall market. It’s basically flat from late October, thanks to weakness in iron ore prices. The financial sector is up around 23% since its lows, while consumer discretionary stocks are up nearly 25%. Gold stocks made their lows in early October, and are up 20% since then.

Guess what the best sector performance is? It’s not tech stocks...

It’s the property trust sector, up 43% from the lows!

This is why it pays to be a contrarian. ‘Investors’ were panic selling the sector back in October last year on the back of rising bond yields.

Whenever there is panic selling, there is nearly always a bargain. It’s just a matter of time before subsequent price action confirms the bargain price.

Back at the lows, I wrote to members of my advisory service:

REITS are really on the nose right now. No self-respecting investor will openly admit to owning them or wanting to buy them.

Everyone hates office property…

Everyone thinks valuations are too high and must come down…

Everyone knows that rising bond yields are bearish for REITS…

Which is why the discerning investor must be willing to allocate some capital to the sector right now.

I had the good fortune to recommend Charter Hall [ASX:CHC] right at the lows. Since then, it’s rallied over 55%.

Nearly six months later, it’s a completely different story when it comes to the market in general. Back then there was panic selling. Now, in some cases, there is panic buying. It is not widespread, but it is very important to think like a contrarian at the highs as well as the lows.

In a moment, I’ll show you a popular bull market stock where it’s clear that investors are not thinking rationally about its business and prospects.

In bull markets, offering stock tips is easy. So is taking them. The hard part is realising that rising prices mostly reflect positive investor sentiment and confidence rather than genuine increases in intrinsic value.

On average, businesses grow around 8% per annum. If the stock market increases faster than this in the short term, it necessarily means future investment returns will be lower.

But paradoxically, a substantial rise in the market like we’ve seen makes people believe the future will be even better and that investment risk is low. When the crowd thinks a certain way, it’s hard not to follow along.

At times like this, we should take counsel from the masters. In The Intelligent Investor, Ben Graham wrote:

Your shares have advanced, good! You are richer than you were, good! But has the price risen too high, and should you think of selling? Or should you kick yourself for not having bought more shares when the level was lower? Or – worst thought of all – should you now give way to the bull market atmosphere, become infected with the enthusiasm, the confidence and the greed of the great public (of which, after all, you are part), and make larger and dangerous commitments?

Presented thus, in print, the answer to the last question is a self-evident no, but even the intelligent investor is likely to need considerable will power to keep from following the crowd.

Indeed they will.

But it helps if you look at the numbers and make a rational assessment of the business. The numbers don’t lie. It makes it harder to get swept up in the emotion of the market when you simply focus on what the numbers tell you.

This gives you a foundation from which to ask, ‘what is the market thinking, and what is the probability of that thinking being right?’

With that in mind, let’s look at a company where the market has, in my view, gotten carried away. And it relates to the current AI craze.

The company is Next DC [ASX:NXT]. It’s up over 50% in the past five months and now has market value of around $9.1 billion.

What does that get you?

19 data centres around Australia, and one each in Auckland, Kuala Lumpur, and Japan. It’s forecast to generate revenue of just over $400 million in FY24, but no profits for at least the next three years. It’s expected to lose around $50 million in FY24 as it continues to build scale.

The net asset value of these data centres (and associated assets) at 31 December 2023 was $2.24 billion, or $4.35 per share. So, at a market value of $9.1 billion, you’re paying over 4 times net asset/book value for this business right now.

Generally, companies that trade at a price-to-book multiple of 4 times or more are highly profitable. BUT NXT isn’t going to deliver profits for at least three years.

And when it does, the profitability will reflect the economics of the business, which is effectively a property infrastructure play. These are capital-intensive businesses. The returns on assets and equity are likely to be modest.

You only need to look at a more mature competitor, the NASDAQ listed Equinix. Inc [NASDAQ:EQIX] for evidence of this. It’s forecast to generate around $1.1 billion in net profit in 2024, giving it a return on assets of just 3.7%. Thanks to leverage, return on equity is forecast at around 9.6%.

In other words, profitability is average, yet the company trades at a market value of $80 billion. That’s just over six times net asset/book value!

What an absurd price to pay for a company with such mediocre profitability. But as Graham wrote in The Intelligent Investor:

The speculative public is incorrigible. In financial terms it cannot count beyond 3. It will buy anything, at any price, if there seems to be some ‘action’ in progress. It will fall for any company identified with ‘franchising’, computers, electronics, science, technology, or what have you, when the particular fashion is raging.

Next DC might not have as ridiculous a valuation, but unscrupulous brokers will point to Equinix as a comparison company and say, ‘NXT is relatively undervalued!’

If Next DC was self-financing, it might not be so bad. But since 2019 shares on issue have increased 50% (representing additional equity capital of $1.465 billion) while net debt is up by around $1 billion.

In the years to come, there is no doubt Next DC will enjoy the cashflows from the substantial investments that it is now making. But the question is, what will the sustainable returns on that investment be?

When the excitement over AI and data centres dies down, which it surely will, investors will realise that Next DC is simply a high-tech infrastructure play and price it accordingly. Unless the economics of the business change, that will be at much lower multiples than the market currently applies.

This is the type of analysis I undertake for members of my service, The Fat Tail Investment Advisory. You can try the service by clicking HERE…it comes with a 30-day money-back guarantee.

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