The Capital Call

David Stevenson is an experienced investment commentator and writer, with a passion for media and technology. David writes for a number of leading publications including The Financial Times, where he is a columnist, the Investors Chronicle, Money Management and trade newspaper Investment Week, where he’s the contrarian columnist.

Analysis of DIGITAL – Looking at the hard numbers

October 4, 2021

It’s official: investing in digital infra stocks really has beaten the big benchmark, the S&P 500, over the last five years or more! I, like many, had always made the assumption that investing in the right tower co, for instance, was a smart strategy, but would the ‘average’ investor have done so well if they’d invested in a diverse basket of digital infra stocks, i.e. would a basket of tech infrastructure stocks have outperformed, say, the S&P 500?

Until recently it was very difficult to answer this question because there was no real world basket to compare with, but a few weeks ago Digital Infrastructure Investor launched their Digital Infrastructure Investor Global Index, ticker DIGITAL. This index went live June 28th and contains 32 mostly well known constituents. I’m sure you’ll hear much more about this new equity index over the next few months, but for now I’m simply curious about what the numbers tell us. What do the hard numbers tell us about investing in tower cos, data centres and fibre operators?

The big, important number is that of returns over the medium term. Usefully, the index has been put through the trusty old time machine that is called a quantitative backtest and the numbers that have come back look impressive. Since 12th April 2015 $5000 invested in the S&P 500, for instance, would have returned $10,400 to date, whereas this index returned over $12,000.

Obviously, back tests come with all sorts of expected caveats, so for me the more interesting story requires a bit more digging around in the numbers playground. In particular, what are the key technical and fundamental numbers supporting this curated assembly of digital infrastructure equity players?

To help answer this I’ve taken the top eleven constituents in the index which trade on either the US or European exchanges and then run that smaller sub set of stocks through the various sources of stock data including Bloomberg, Yahoo Finance and Sharepad in the UK.

Note that these eleven stocks do comprise well over 65 percent of the aggregate value of the index, so although they don’t give us the complete story about the index, they are nevertheless bound to dominate any narratives that do emerge. On the issue of geography, many of the longer tail of 21 stocks in the wider index are not listed in either the US or Europe, and thus underlying financial data is patchier.

So, digging around inside this shorter list of 11 (out of 32) names reveals some interesting insights, not least the fact that these stocks have collectively beaten the S&P since the middle of the last decade. In terms of longer time scales, more than a few of the businesses haven’t been around more than five to 10 years, but for the six that can boast a 15-year share price track record, the total shareholder return including dividends has been a stonking 783 percent versus 229 percent for the S&P 500.

That said, I think the most interesting insight is a technical one. The average beta across these large cap tech stocks over the last five years is a relatively lowly 0.4 (to the S&P 500), while the average correlation over the same time is also a relatively lowly 0.486. These two numbers would suggest that the big digital infrastructure names aren’t really your classic momentum players and thus they might offer some diversification benefits for an equity investor. Yet there is a price to pay – the average volatility of these top 11 stocks is double that of the benchmark S&P 500 index. So, these infra stocks potentially offer some diversification benefits but at the price of greater price volatility.

What about valuation metrics? The consensus view has long been that these stocks are collectively more than a tad overpriced. The numbers tend to back this up. The average price to earnings ratio – if there is one – is well over 100 times earnings and the average price to net asset value is a slightly eye watering 19.5 times. But before we mark this down as a win for the valuation critics, it’s also important to consider some other hugely important numbers.

The first is that the dividend yield, where dividends are paid, is a generous 2.57 percent versus 1.28 percent for the S&P 500 benchmark, and that doesn’t include any share buybacks. In addition, it is clear that these businesses are veritable cash machines, producing lots of free cashflow based off surging turnover growth. Using analysts’ estimates for the coming year, this cross section of 11 stocks is expected to grow turnover by around 20 percent in the coming year.

That in turn translates through into an average forecast earnings per share growth of 81 percent across the 11 stocks in the coming financial year. So, whilst it’s true that buying into these digital infrastructure stocks does mean paying a very substantial premium against the benchmark, you’re also on the receiving end of very strong both top and bottom-line growth which is feeding through into cash pay-outs to shareholders.

Now, many investors might still think that these valuations are aggressive (and they are in my view) and they may also point to high gearing across the sector – running in the hundreds of per cent for these 11 stocks on average. But I would suggest that for many investors the obvious growth characteristics of this space plus its collective diversification benefits might be exactly what they need to ignore these valuation concerns. And certainly, most analysts don’t seem to be too put off by the rich valuation metrics – the average broker rating across the sector is 2.2, with one representing very bullish and five very bearish. It’s also worth noting that the average short ratio is five, which doesn’t seem terrifically bearish.

Stepping back from this tsunami of numbers, a couple of points do stand out for me. The first is that these valuations do demand that the digital infrastructure giants deliver on their growth promise. A quarter or two of disappointing numbers or even a year or two of underwhelming growth could spell trouble because of those rich valuations. My sense is that given the secular demand profile of this sector, that shouldn’t be too great a risk, but given the obvious scramble to build new operating assets, there’s always an ever present risk of a supply glut which could hit margins.

The other obvious point is that high gearing is fine if growth in the bottom line – profits and free cashflow – is surging. But that situation could turn nasty if interest rates and bond yields start to rise and cashflow growth slows down. That could be a dangerous double whammy that could in turn smash those dividend payouts. On that point I’d note that the average dividend cover for these 11 stocks is a lowly 0.5, which suggests that dividends could be vulnerable if free cashflow starts to wilt.

Previous Columns from David Stevenson