VPN ETF: Tailwinds And Headwinds

Where there is data smoke, there is business fire. – Thomas Redman

Introduction

I’ve been highlighting the sideways movement of the Real Estate sector for a while now. A slowing housing market is a headwind, but at the same time, investors view the group as a defensive play. Not all parts of the REIT sector, however, are as conflicted. Within the REIT sector, there’s one sub-segment that has been demonstrating decent strength since the start of November. As captured in the image below, a relatively new product (it was set up only in Oct. 2020), the Data Center REITs & Digital Infrastructure ETF (NASDAQ:VPN) has delivered double-digit returns, outperforming a diversified REIT portfolio by more than 2x, and the S&P500 by an even greater margin.

Despite the recent outperformance, it also appears as though VPN still looks relatively oversold versus the broader real estate sector. While this may bode well for investors who are guided by the notion of mean-reversion, one shouldn’t get carried away as there are a few other factors to consider.

Tailwinds and Headwinds

There are both good and bad reasons to pursue this product. In recent years, we’ve all come across content highlighting the exponential growth in data, a trend that is likely to linger for the foreseeable future. IDC believes that global data creation and replication will grow at a CAGR of 23% till 2025. The proliferation of next-generation tech such as 5G, IoT, and AI in our lives will keep demand for digital infrastructure flying. For instance, just consider the relentless pace of 5G adoption across the world. As noted in The Lead-Lag Report, 5G smartphone subscriptions could spiral by over 3x within the next 4 years!

As the penetration of these technologies deepens, we’re going to need ample data-center infrastructure to manage high-intensity data applications and storage. It’s questionable if the requisite capacity is there. For instance, according to CBRE, in the North American region, demand for data center capacity in the North American region alone more than tripled YoY in H1-22. On the cost base, when inflation has been a dominant talking point, it also helps that data center REITs generally have a lower level of labor costs compared to other REITs.

Conversely, what works against these data center operators is their relative over-dependence on a selected cohort of cloud firms encompassing the likes of Microsoft (MSFT), Amazon (AMZN), and Google (GOOG) (GOOGL). We could get to a point where these companies start dictating unfavorable lease terms on account of their massive clout. A parallel risk to consider is that these mega corps have also recently begun developing their own data center facilities; could the scale get to a point where our data center REITs are in direct competition with their own clients?

Data centers also run the risk of facing plenty of collateral damage on account of a wobbly power grid that impacts the power supply needed to funnel any growth. Recently, we saw some incidents in Northern Virginia (which is believed to be the world’s largest data center hub), where the utility expressed concerns over meeting the power requirements for data centers. If utility companies are unable to accurately budget for the requisite power requirements, a lot of stocks that belong to VPN could face some reputational damage.

Data center assets have also traditionally received a lot of attention from the private equity sector, but in the current environment, where financing has become even more challenging, it’s hard to get too excited.

Conclusion

One of the reasons why VPN may not necessarily benefit from potential mean-reversion momentum is that the AFFO (Adjusted Fund From Operations) valuations of its dominant holdings are quite steep. As highlighted in the image below, on a forward price to AFFO basis, the bulk of VPN’s top holdings is currently all trading at steep valuations relative to the sector median figure of ~15x.

Also note that this ETF doesn’t only comprise of REITs (58% of holdings), you also have stocks from the technology, communication services, and industrials all of whom come from the growth side of the market (VPN covers not just companies that operate REITs but also those involved in the digital infrastructure behind the growth of communication networks).

As noted in the weekly risk signals section of my subscription research, conditions suggest that it would be imprudent to be overweight on equities, and in an environment such as this, high-beta growth segments may end up becoming chief victims of a potential accident.

VPN is also quite a steeply-priced product, with a current forward P/E of almost 30x! Crucially, after paying an elevated multiple of that sort, investors will likely only witness long-term earnings growth of 11% or so.

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