MASTERCLASS: Real Assets - April 2018

As the Federal Reserve looks to stoke the coals of inflation, how can you protect your portfolio from its erosive power? Real assets are key diversifiers that become increasingly important in a rising inflationary environment.

  • Kevin Baum - Chief Investment Officer at USCF
  • Ryan Dobratz - Lead Portfolio Manager, Real Estate at Third Avenue Management

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  • 47 mins 04 secs

Gillian: Welcome to Asset TV, I'm Gillian Kemmerer. As the Federal Reserve looks to stoke the coals of inflation, how can you protect your portfolio from its erosive power? Real assets are key diversifiers that become increasingly important in a rising inflationary environment. Today we have a panel of experts here who are going to tell us more about the real assets landscape and the opportunities that they are taking advantage of. Welcome to the Real Assets Masterclass. Thanks so much for joining us. And you’ve braved the New York snow, so we very much appreciate it. I’d like to just kick off with introductions. So maybe, Kevin, you can start us off. Tell us a little bit about yourself in your role at USCF? Kevin Baum: Sure, I’m the Chief Investment Officer at USCF Investments. And we’re a commodity focused exchange traded provider shop. Gillian: Excellent. Thank you, and Ryan. Ryan Dobratz: I am a Portfolio Manager and Partner at Third Avenue Management. We were founded by Marty Whitman back in the 1980s. Today I have about 4 billion of AUM, more than 2 billion of which is focused in real estate. And I’m the Manager with my partner, Jason Wolf on the Third Avenue Real Estate Value Fund. Gillian: Excellent. So we have a nice diversity of perspectives here on real assets. So I think it might make sense, given that it’s such a diverse asset class to begin with a definition. So, Kevin, I’ll kick it off with you, how do you define the universe of real assets? And would you say your definition differs from the benchmark definition, for example? Kevin Baum: Well, when I think of real assets I think hard assets or tangible assets, things that you can see, touch, consume. So that would be anything from real estate, timberland, farmland, but also of course, infrastructure and commodities. So again it’s a diverse suite of assets that falls under the real asset umbrella. Gillian: Now, what about something like TIPS? Kevin Baum: TIPS is often included in that basket. TIPS of course are financial assets and they have different risk characteristics. But they do have that inflation hedging property, which is why many people include them in the real asset category. Gillian: Okay. So for you specifically it’s the tangibles that you focus on? Kevin Baum: Mostly, correct. Gillian: Mostly, okay, Ryan, what about you. Ryan Dobratz: I mean for us that is very much the case. As a real estate fund, we’re a little bit more limited in scope. But it’s certainly important to note that Third Avenue Real Estate Value Fund has a much more flexible mandate than a traditional real estate fund, in the sense that we can invest in not only REITs, but real estate operating companies, and some real estate related businesses. So we do own and invest in timberlands, and land development companies, home builders, brokerage companies etc. So we have a very sort of wide mandate relative to a lot of other traditional real estate funds. Gillian: So it’s not just the real estate, but it’s anyone that touches it really, could be within that bucket? Ryan Dobratz: Yeah, absolutely. And it’s frankly been one of our biggest competitive advantages over the years, to be able to invest in some of these other areas of real estate, yeah. Gillian: So let’s talk a little bit about the global picture that we’re facing now, and perhaps we are a fair bit lucky. But we’re looking at a goldilocks scenario of sorts, so strong global growth, some strong valuations. Ryan, kicking off with you, is it set to continue, how do you think about it? Ryan Dobratz: Yeah. We have the view at Third Avenue that as the recovery continues on, that correlations are starting to break down. So we think that you’re going to have very differentiated performance out of certain countries, certain industries, different companies etc. So there are pockets of the real estate universe that should continue to do quite well. If you were to look at the industrial real estate space, companies like First Industrial in the US, and [inaudible] in the UK that own these warehouses. They’re benefitting from secular changes in demand for that space, given the rise of ecommerce. So that’s an area where you could continue to see things continue to do quite well. There are other areas like datacenters which you’re seeing a lot of supply, you’re seeing technological changes, if you look out over 3-5 years, things might not be as great there. So there are pockets that should do quite well. But as correlations break down, other areas might not perform as great. Gillian: And when you specifically think about those correlations, what are you … can you give us some examples? Ryan Dobratz: Yeah, in terms of, I guess, the correlations or the different performance, it really comes down to just fundamentals. And so we’re looking at opportunities within certain countries, we would tell you that there are great, great opportunities right now in the UK, because of uncertainty related to Brexit, big discounts, also big opportunities in certain property types like industrial real estate, residential. Where there are some other areas that just aren’t that attractive. So it’s really more about fundamentals in terms of determining what we think will work over the next 3-5 years. Gillian: So the research I would imagine is key. But it’s interesting; Brexit so often is looked at as a negative or an uncertainty when dealing with investment. But here it may have created an opportunity set. Ryan Dobratz: ] Absolutely. If you take a long term view, you can make the case that London is still one of, if not, the best places to be a real estate investor on a long term basis. But because of this uncertainty a lot of companies there are trading at big discounts to the underlying value of their real estate. And so looking out 3-5 years you can buy in today at 60/65 cents on the dollar. And ultimately that discount should close as conditions improve, as there’s more clarity around Brexit, or if private equity groups step in and buy some portfolios. We actually have an investment in the fund today, Hammerson; they’re one of the largest mall owners in the UK. They’ve been trading at a discount because of the uncertainty. And they’ve been approached and are likely to be bought at a price closer to the NAV. So there are certain opportunities like that out there in the real estate space. Gillian: Now, Kevin, I want to bring you into this conversation. When you look out at this goldilocks scenario, do you believe it’s set to continue, how do you think about it? Kevin Baum: Well, it is goldilocks for real asset investors. We’re talking about synchronized global growth. We’re talking about rising inflation pressures. These are things that historically have been the perfect environment for a real asset investor in commodities specifically. So we do think that that continues for some period of time. But we also recognize that we’re in the later stages of the economic cycle. And again that’s when you often see picking up on this correlation discussion, that the correlation between real assets and financial assets tends to be low and you’re really getting that diversification benefit. Financial assets often lead the business cycle, tend to roll over a little bit sooner, and that’s really when your real assets can come in and protect the portfolio. Gillian: Yeah. When we look at something like the demand for commodities is that predicated on this continued strength of global growth? Kevin Baum: Absolutely. I mean there’s a direct link between energy demand, industrial metals demand to global growth. So there’s no question about that. And specifically emerging economies, that’s really where we see the strong growth rates in demand. But I think it’s also worth noting that supply has been depressed for commodities. And we have these long cycles in commodity production where it’s all dependent upon producers spending in their CapEx where we’ve seen a very constrained environment for natural resource producers spending. And so that’s not allowing supply to keep up with demand in the current environment. And we think valuations, if you want to use that term, are very attractive in commodities right now. Gillian: I’d like to talk a little bit about the outlook for inflation, because obviously we have a Fed decision coming just in 30 minutes or so today, so it’s good timing. The Fed’s really trying to stoke the coals of inflation. Talk to me a little bit about how your areas of focus will perform if they do succeed in doing so. Kevin Baum: [0:07:49] Well, I agree with you completely, when we talk about again, inflationary pressures on the rise, we talk about low unemployment, we’re starting to see a little bit of wage growth for the first time. Fiscal stimulus is now starting to impact markets, also trade tariffs. That’s by definition inflationary. So we do think we have a confluence of factors here that are coming together to create some upside surprises in inflation. Now, historically, again, what we see with inflation is commodities are positively correlated. But more importantly, it’s not just the level of inflation, but what direction is inflation moving, is it rising? Is it falling? And I’ll give an example, over the last 45 years, if you look at rising inflation environments, versus disinflationary environments, commodities have outperformed stocks over 20 percentage points per annum in a rising inflation environment. Stocks have outperformed commodities by about 20 percentage points in a falling inflation environment. So I think this is a critical topic and something that advisors need to be really conscious of in the current environment. Gillian: That’s an impressive performance differential. Ryan, how do you think about inflation? Ryan Dobratz: If we’re getting inflation for the right reasons, stronger economic growth, higher wages, higher retail spending etc, it’s really, really good for real estate, both commercial and residential. The issue is that a lot of real estate securities have been used as almost bond proxies over the last 5-7 years. And so if inflation picks up and rates go up, the dividend yield that a lot of those securities provide, like REITs may not be as attractive. And so what we’ve been doing for the past few years is trying to position our portfolio, the Third Avenue Real Estate Value Fund to not only, one, protect capital in a rising rate environment, but two, potentially even benefit from it. And so we’ve been trimming back sort of our exposure to REITs, investing in real estate companies that have more durable value, so also adding positions that could do really well in a higher inflation, higher economic growth environment. And we think that that is working. I mean if you were to look back at how the fund has performed since the election of 2016, rates since that point in time are up about 110 basis points on the 10 year. The US REIT market is flat, when including dividends. And Third Avenue Real Estate Value Fund’s up about 25%. And so we think that that shows that real estate can work in a higher inflationary environment. You just have to have the flexibility to get to the right areas that are going to do well in such a scenario. Gillian: Now, you mentioned inflation for the right reasons. And I direct this to the both of you, what if it’s inflation for the wrong reasons, like say protectionism? Kevin Baum: [0:10:25] Well, you’re right, inflation can happen for a number of reasons. And it’s important for investors and advisors to keep that in mind. It can be cost push inflation, commodity spikes that can cause inflation. It can be monetary conditions. There are a number of things, like you say, protectionism, trade wars. Again these things can all lead to higher levels of inflation. But the one thing that we know, the common denominator here is that upside surprises of inflation tend to be negatives for financial assets. So again, there’s a number of factors we can point to, a number of conditions that could cause inflation in the current environment. But very few of those end up being good for financial assets. Gillian: So. Ryan Dobratz: Yeah. You know, real estate is a terrific place to park capital and to protect it from inflation over time. If we’re getting a stagflation like scenario that could certainly be disruptive in the shorter term. But well located real estate, that’s owned by well capitalized companies, will ultimately store that value and protect it over the course of time, yeah. Gillian: Now, I think that we have defined this to some extent already. But I want to drill down a little deeper. We’re just thinking about the role of real assets in a portfolio. But particularly in an area like we are right now, we still are in a fairly low inflationary environment; we’re not at The Fed’s 2% mandate. And we’re also, we’ve so far been low volatility, you know, February obviously threw a wrench. So how do you think about real assets, what are they supposed to be doing right now? And we can talk about, you know, higher inflation later. Kevin Baum: Sure. Well, I think you want to include real assets as an evergreen allocation in a portfolio. So as a strategic investor you should always have let’s say 10% of your portfolio allocated to real assets. But the beauty of real assets of course is that you can diversify within that bucket. So whether it’s real estate, whether it’s commodities, whether it’s infrastructure, they’re all doing slightly different things and have their own unique characteristics. But I do think investors are now starting to focus on inflation for the first time in a long time. But first and foremost it’s diversification. You know, real assets again have low correlations to stocks and bonds. So their return dynamics are different at different points of the business cycle. That really does protect a portfolio in those environments where stocks or potentially bonds are declining in value. So it’s diversification, inflation protection, and of course return potential, just as Ryan was mentioning. Gillian: Ryan. Ryan Dobratz: Yeah. I mean when you look at commercial real estate, that really durable cash flow streams that those properties provide remains very, very attractive in a lower rate environment. But you have this option to participate on the upside if we do get higher inflation. So it almost acts like sort of a bond with an inflation kicker in it. And that should be attractive to a lot of investors in this still lower rate environment, yeah. Gillian: Now, Ryan, I’m going to stay with you for a moment. Obviously we have a lot of legislative and geopolitical events on the agenda. And instead of prescribing one, why don’t you tell me about some of the ones you’re keeping an eye on. Ryan Dobratz: Yeah. I mean, you know, taxes are certainly impactful, both domestically and internationally. You know, I would say that our fund has benefitted, probably disproportionately from the recent tax changes. Because we have the ability to invest in REITs and operating companies, about two-thirds of our investments are actually in real estate related businesses or real estate operating companies. So a cut in taxes is great for their bottom line. In addition to that, one other thing that we’re paying obviously very close attention to is some of the changes on the SALT side of things, right. A lot of very urban dense populated areas have been disproportionately impacted by the sort of removal of the SALT deduction. And so it’s not happening immediately, but if you look out over 2-3 years you may see corporations start to move employees. You may see others start to move to lower tax based areas. And so that’s something that we’re certainly monitoring as it relates to real estate and demand for properties. Gillian: So would you say that, for example, the corporate tax cuts would be a tailwind regardless, but the elimination of SALT etc, when we look at some of these higher tax states could potentially be a headwind too? Ryan Dobratz: Absolutely, there’s no doubt about it. And it’s going to take a little bit of time for that to work its way through. Near term it’s been a little bit of stimulus for our investments. But we’re certainly taking into account what the sort of medium to long term changes of this might be. Gillian: So stay tuned. Kevin, what are you keeping an eye on? Kevin Baum: Similarly when we think about some of the tax cuts, that’s stimulative to growth, which is stimulative to demand for commodities. Also looking ahead we think there’s some other important dates on the calendar. We have an OPEC Ministerial Monitoring Committee meeting in about a month’s time. And we have a full OPEC meeting in June, which of course will be important to energy prices. And so there are a number of things on the horizon. And of course let’s not lose sight of the potential for an infrastructure spending bill. And of course that would be supportive of energy and even more specifically, industrial metals. So there’s certainly things on the calendar that are going to influence price action in the commodity space in coming months. Gillian: I'd like to dive a little deeper into some of those geopolitical and OPEC related events as we move into the opportunity set. So we have a nice macro picture now, we understand real assets in their world within a larger portfolio, so let's talk a little bit about each of your areas of focus in your investment process. So maybe Ryan you can kick us off, give us a quick primer on how Third Avenue purchase real estate investment. Ryan Dobratz: And we've been told that our approach to investing in public securities is actually more similar to a private equity like approach in terms of investing in portfolios and companies. Because we do a lot of our work upfront, we're typically buying into companies or areas that are out of favor. So we want to know a lot about the businesses, the management teams, the assets, etc. And on average we hold those investments for about 4-5 years, until conditions improve, the security prices rebound, etc. And so what we typically do is we'll go visit properties, projects, meet with management teams, talk to brokers, their peers etc. Put that into maybe about a 15-20 page document. That sort of summarizes the opportunity that's set out, not only to the real estate team, but their broader investment group at Third Avenue. We discuss that investment opportunity and then decide if it's suitable or not. If it's suitable we've got to figure out, if it's suitable, at what price. In the rare case that it's suitable at that price today, it goes into the fund, if not; it goes into our shadow portfolio. And we found that over the course of years, we've been running this firm for nearly 20 years now, most of our new investments come out of that shadow portfolio when there are sort of macro concerns that create a lot of market volatility. So we do a lot of work upfront, we track companies for years, and then when there is the sort of big event that sends a security price down 10/15% we're able to step in and put companies into our portfolio. Gillian: And very much a boots on the ground approach? Ryan Dobratz: Yeah, absolutely. Gillian: Kevin, what about your process at USCF? Kevin Baum: Well, it's interesting hearing Ryan talk about things that are out of favor. We know commodities have been out of favor, right. When we look at rolling 10 year returns, for stocks they're up in the top decile, even the top 5%. The rolling 10 year return numbers for commodities are in the bottom decile of their historical return profile. So we do think commodities are very much out of favor at USCF investments. But we offer passive products, we offer exchanged traded products on single commodities which can serve as trading vehicles, if you're interested in, for instance, the oldest and largest oil fund, USO. Similarly, financial gas we have UNG. But when we think about commodities as an asset class, and for advisors that want to diversify a portfolio, we really think a broad basket approach, something like our fund USCI is the right approach to take. So now you're getting exposure to energy, industrial metals, precious metals, agriculture. So the full spectrum of commodity sectors, and what that does again is give you the diversification at the asset class level, and then of course the low correlations and diversification against stocks and bonds. So it's a passive approach. But it's an intelligent index. So people use the term smart beta, you can consider it a smart beta product. Because what it's doing is rather than a production weighted or capitalization weighted index. Our fund is benchmarked to the SummerHaven Dynamic Commodity Index, which uses a couple of filters, the first being fundamentals, what are inventory levels? What is the shape of the forward curve for commodities? So we're avoiding the commodities that have the greatest headwinds from those maturities, and we're allocating to the 14 commodities in our opportunity set that have the most favorable economic conditions or fundamentals. So it's a best in class product, it's the only five star Morningstar Fund in the broad basket commodity ETP landscape. So we think it's a best in class product. Gillian: Excellent. So now that we understand how you think about the investment universe, I want to dive into some of the different opportunities. And we'll kind of go back and forth with theses that you've been interested in, and I've had the pleasure of learning more about as I've spoken with you. So, Ryan, I'm going to start with you. Why don't you tell us about your biggest exposure, which is companies with ties to US residential markets? Ryan Dobratz: We have about 35% of the fund’s capital invested in companies that have really strong ties to the US residential markets, in particular the construction of new homes. As we know, the US markets essentially went through great depression like conditions on the residential front in sort of 2008, 2009, 2010. On average if you look back, I guess, over the past six years we've built on average about 1.5-1.6 million homes per year. In 2010 that fell all the way below 500,000. And we're slowly working our way back up. We're building about 1.2 billion homes per year now, But if you look at it, most major markets in the US there are now shortages of home, inventory levels are at record lows, and there is a lot of pent up demand for new housing. And so when you take a 3-5 year view, we think that companies that are going to be able to deliver new homes and provide the inputs through that process are going to do really, really well. And so we have a very diverse set of companies that have ties into that process, including Lennar which is the largest homebuilder in the United States, they're going to deliver probably 40,000 homes this year. We have big positions in Weyerhaeuser [inaudible], collectively they own about 20 million acres of timberlands, providing logs and lumber into the building process. We have a big investment in a company called FivePoint, they own great land out in California. They can accommodate 40,000 new homes and 20 million square feet of commercial. We also own F&F Group, the largest title insurance player, as well as Lowe’s, the big home improvement retailer. So those are the companies that, you know, make up the bulk of that 35% exposure, and that we think will be providing, you know, much higher levels of earnings cash flows when looking out over the next 3-5 years. Gillian: Now, you mentioned California specifically, but when we look at these other suppliers, are they supplying nationally or are you taking bets on specific regions in the US in the residential market? Ryan Dobratz: Yeah. When you look at our exposure, it's really California and then throughout the south, and a little bit up through the mid Atlantic. So it's very much focused on where we're seeing significant levels of population growth, in terms of costal California, throughout the south and mid Atlantic. Gillian: Ryan, obviously your mandate allows you to go global in your portfolio, so talk to me about some international opportunities you like right now. Ryan Dobratz: Yeah. We have actually about half of the fund’s capital invested overseas. Two areas where we see a tremendous amount of value right now are, one, in the UK, and then, two, also in Asia, ex Japan, which for us is Hong Kong and Singapore. In terms of the UK, as I mentioned, you know, we think London is one of the, if not, the best property market, sort of on the planet for long term investors. It's a terrific place to do business with a global perspective, just from a time zone location, you interact with Asia in the morning, you interact with North America in the afternoon, in, you know, in London you have rule of law, there are barriers to entry, it's very difficult to build new product, it's for a lot of reasons a great place to own real estate. If you would have looked back at the fund in 2011, 12, 13 and 14, you would have found that we had a little bit more than 20% of the fund invested in the UK. Particularly coming out of the financial crisis, but a lot of those securities did really well. So we trimmed them back and sold them, as they approached sort of our estimates of fair value, we had a few investments taken over, we had a big investment in Songbird Estates that owned Canary Wharf, which was taken over by a private equity group. And so that exposure fell all the way back down to about 6% going into Brexit, and then once Brexit hit, security prices were down 30-40% overnight. So we jumped back in, and put a lot of capital to work and took our exposure in the UK back up to about 13%. And that's where we sit today. And there's certainly going to be more issues that come out of the Brexit process, there are going to be more questions. But if you look out on the other side, we think that London will remain one of the best places to be a real estate investor. And ultimately the value in these companies will shine through. So we do have a fair amount of capital invested there today. Gillian: And what about Hong Kong and Singapore? Ryan Dobratz: Yeah, Hong Kong and Singapore is a little bit of a different proposition, in the sense that there aren't a tremendous amount of questions about whether those markets are going to continue to be as relevant with changes in how they interact with the rest of the world, like we might see in London. But what you're getting in Hong Kong and Singapore are similar levels of discounts. Most of these companies are trading at 30-40% discounts, despite owning really high quality assets and being great, run by line management teams, the difference there in Hong Kong and Singapore is that a lot of them are family controlled businesses. And so there's no prospects for a change of control, in the sense that if a company trades at a 50% discount, it's not like a private equity group where a peer can step in and buy that business, because the family can just block it. But what we're seeing over there now is a lot of these companies and their founders, the tycoons of Hong Kong and Singapore are passing over the management of the businesses, either to their children, or to more professional management teams that are taking steps to streamline those businesses, as well as improve their capital allocation policies, and the corporate governance practices. And so as this plays out over the course of a few years, we think the valuations for a lot of these companies in Hong Kong and Singapore which are really blue chip businesses, will improve and, you know, investors can make a lot of money by being patient and letting that process play out. Gillian: Kevin, moving to you. I want to talk a little bit about the forces at play in the energy market right now. Obviously the US has popped up as perhaps the swing producer of late. We have some movements in OPEC, etc. What are you thinking about right now? Kevin Baum: Well, Gillian, you mentioned goldilocks earlier, it's a goldilocks environment for energy right now. Again, synchronized global growth, we've had upside surprises in oil demand, and again we've had constrained supply. And OPEC, you mentioned OPEC, that's a perfect example. They announced cuts back in December of 2016. So we're about 14/15 months now into those cuts, and we see that that has also constrained the supply environment. So what we're not experiencing is depleting inventories. Inventories of course have been very high coming out of the price, we're going to definitely going to have to do some [inaudible] work there, but coming out of the price decline. But what we're seeing now in the US for instance is that last year, US oil inventories declined over 110 million barrels, historically on average we see about a 40 million barrel decline from the summer peak to the end of the year. So inventories are normalizing. OPEC cuts have a lot to do with that. Now, what that’s created is a stronger fundamental environment, so we think it shifting the price range higher. We're coming out of that 40 to low $50 oil price environment that we have been in, and we think we've now shifted into an environment, maybe pulling $10/15 higher, mid 50s upwards of 70. Now, again that's not an unlimited ceiling. We do have the potential for OPEC to unwind some of their cuts, of course that could pull a little more supply back in the market. You mentioned US shale, they are price sensitive, and it's short cycle, so we could see increasing US shale supplies, and we suspect to see that, frankly. But we still think we're in a fundamentally healthy environment. Again, we talk about synchronized global growth and things that are helping commodities in general, but energy specifically. Gillian: And what about the Iran sanctions review, what are you thinking about here? Kevin Baum: It's important that you bring that up, but when we look ahead to May, President Trump has a decision to make on whether he renews the lifting of some of the sanctions. Of course if he doesn't, and those sanctions go back into effect, we think that'll constrain supply from Iran. Now, in addition to that, no one's talking about Venezuela, but I think we should. Geopolitics, Venezuela's at the top of my list. We've seen supply declining, or production declining in Venezuela in recent years because of, of course the political crisis that they're having within the country. But we also think it's possible that the US may impose some sanctions on Venezuela, which will accelerate that process. So there are regions of the world where we're actually expecting supply to decline rather than increase. And again with demand growing this is a favorable environment for energy prices. Gillian: Kevin, I recently read that the US may surpass as the largest producer of oil, and in fact become the swing producer. How will that impact the dynamics, both at home and abroad? Kevin Baum: [0:28:02] Well, many people had written OPEC off as the swing producer, and we think that's a bit premature. OPEC still matters, the production cuts that have been going on now for 15 months have certainly been supportive of energy prices. And their decisions in coming meetings will matter. But we increasingly think the US is becoming the dominant swing producer. The US now of course is producing about 10, almost 10½ million barrels a day of oil, more than 50% of that is shale production, and it's very short cycle price instead of production. So we think as prices rise you'll continue to see shale production move higher. That of course is supportive for many of those companies, but also a lot of the infrastructure that needs to be built out to support that. So MLPs become an interesting area, again, especially with the current selloff. But back to the US becoming the swing producer, the way we think about that in USCF Investments is, we're somewhat agnostic about it. Of course higher prices is good for commodities in general. And we do have products like USO, which is the largest oil ETP in the world. But we also have a [inaudible] oil fund, DNO, which allows people to play this trading range, or even the three times levered products, USOU and USOD. So if you're looking to make a tactical allocation or trading decision we offer those products to the marketplace. So we think that's exactly right. US shale production will be the swing producer and probably create a trading range, again from the mid 50s to maybe $70 a barrel in the short term, until fundamentals dictate a different trading range. Gillian: So the real impact of US shale is that it probably puts a ceiling? Kevin Baum: Somewhat of a ceiling. Again, the general fundamental market is strengthening, but there is a ceiling there with more US shale supply coming online. Gillian: Ryan, I'm going to come back to you and talk about another area that you've been interested in. What are some of your thoughts on retail? I feel like so often we talk about it with a sort of throwaway, or let's not go there. How do you approach it? Ryan Dobratz: Retail is definitely out of favor. Frankly, it reminds us a little bit of investing in the US residential space back in 2010/2011 where there just weren't that many positive signs out there. Retail is under a tremendous amount of pressure, particularly given that the changes with ecommerce, and just changing shopping habits in general. But if you look at the US retail sales here are just north of about $4 trillion a year, about 90% of that still takes place in brick and mortar. So you're talking about essentially $3½ trillion of sales in shopping centers. So there's still a tremendous amount of value left in brick and mortar. And so everything is being penalized right now. And we're taking a medium to long term view to try to capitalize and find the opportunities, find the retail real estate is going to do quite well over the long term. And so we've focus really on three areas. We've made investments into destination malls, these are the class A malls that serve as the main place for shoppers and retailers to interact in a major market. Two, we are also investing in street retail in cities like New York, like London, like Hong Kong, where shopping center space is very scarce, and so street retail has very limited competition, and frankly a very captive audience. And then three, we're also investing in certain retailers that own a lot of real estate. Third Avenue's historically made a lot of money in mining some of these real estate rich retailers for value. And right now we have an investment in the debt of Neiman Marcus, which is a department store operator that's under a little bit of pressure, but controls really, really incredible department stores at some of the best malls, very valuable real estate. And there are a number of others that we're looking at. So retail's under pressure, but we think that there is value in destination malls, in street retail, and even in some of these real estate rich retailers. Gillian: So shopping is not dead. I'm glad to hear it. Kevin, I want to come back to you. Agriculture is something that you mentioned on the phone, which is something I don't hear about very often. What's driving interest in the sector right now? Kevin Baum: Very little is driving interest in the sector, and that's precisely why I think its worth spending a couple of seconds on that. Again, when we look at commodities, there are some common characteristics, global growth, the US dollar, inflationary environments. So there are some common denominators there. But there are also some factors that are unique or specific to each sector, and even the individual commodities within those sectors. So agriculture has been out of favor, unloved for a good period of time now. So supplies have been favorable, growing conditions in both the northern and southern hemisphere have been favorable to high yields and high inventories, and that's depressed prices. But we think that it's inevitable that you're going to have a weather problem. It's hard to predict when that will be, is it going to be this summer in the US? Is it going to be next winter in South America? It's hard to know. But the point I would like to make is, is that agriculture's been so out of favor, it's a spring loaded coil, whenever that supply disruption does occur, you're going to be surprised at the upside moving prices in the agriculture sector. So it's something to keep an eye on. But more broadly, Gillian, I'd point out that again going back to the difference between commodities and financial assets in the current environment, you mentioned valuations of equities, which are pretty rich right now. Well, in the commodity space it's completely different. Stocks are a 100% above their pre-crisis peak if we're talking S&P 500, and as that composites about 200% above its pre-crisis peak. When you look at each of these commodity sectors, they're anywhere from 40-100% below their peak over the last 10 years. So we think that there are attractive valuations in commodities, and funds like USCI have a lot of upside potential in this part of the cycle. Gillian: Now, agriculture's arguable always important, people are always looking for food supply, so is it really just the oversupply that drove some of the prices down, or would you say there are other forces at play? Kevin Baum: Well, there are, you had strong dollar for a period of time. And of course a strong dollar is a headwind for all commodities, and specifically agriculture. But again we think that the environment sets up very favorably. We haven't talked today about demographics, but with population growth around the world, that clearly means more consumption of agriculture; it means more consumption of energy, of metals. So the long term dynamics are favorable of course for agriculture. But again, short term everyone has been postured very bearishly in that sector. So we think people will be surprised at the move when the supply disruption comes. Gillian: So a strong long term play? Kevin Baum: Right. Gillian: So, Ryan, coming to you. Very often when I speak with investors in real estate, some of them are trying to chase the technological trends and the real estate tied to that. But that's not necessarily your approach. How do you think about tech? Ryan Dobratz: Yeah. Technology is certainly impacting every type of real estate. There are certain areas out there that have actually done incredibly well, and have become incredibly popular; cell tower and datacenters are two areas that have really benefited over the recent years. But we really don't have any exposure to those types of assets or those companies, because when we look at them, they've become so popular they're now trading at, you know, 20-25 times cash flow, and as long term value investors, we frankly can't get comfortable that those assets will even be around in 8-10 years from now, because of technological obsolescence, so there can certainly be some changes. And so what we've always done at Third Avenue is focused in on the basic four [inaudible] groups of property, you know, being apartments, being multi ... not only multi family, but industrial real estate retail as well as office. Because not only are there long term drivers of demand for all four of those property types, but there's generally alternative uses for those types of assets provided you own them in well located urban centers. And a good example of that is actually some of these destination malls that we talked about earlier. What you're seeing in the mall space right now is the in line retailers doing okay, actually you're starting to see some of the eTailers, the companies that have just started online and have had success opening up stores, which has created an additional demand for that space. But the department store space is under terrific pressure. And so a lot of the mall owners are actually repurchasing those department stores and putting that space to a higher and better use by bringing in dining, entertainment, other concepts to draw additional traffic. So for us at Third Avenue, taking a long term view we generally shy away from some of these new concepts of real estate and technology instead focusing in on the basic four [inaudible] groups, and especially those locations that have alternative uses should conditions change over time. Gillian: That's interesting because we so often think of ecommerce as the enemy of brick and mortar. But you've mentioned that there are some ecommerce retailers that are opening brick and mortar now as a result of their success. Ryan Dobratz: Yeah. And they have been incredibly, incredibly productive. Look, most eTailers are not profitable. But as they open up a physical footprint are finally getting to levels of profitability. There are significant advantages of having that physical footprint, being able to showcase your products, handle exchanges, and just frankly interact with your customers. So we are seeing a lot of those traditional eTailers open up space which is really beneficial for those companies that own high destination malls as well as some of the urban retail locations, yeah. Kevin Baum: Gillian, I’m going to pick up on something Ryan was saying. And you were talking about technology and catalysts in general. And I think there's an important technology catalyst to consider in the commodity space as well. We think about electric vehicles, and we think about battery storage going forward. Well, that's going to be stimulative to industrial metals demand, copper, nickel, things of that nature. Now, those are longer term trends, again now we're looking out 5/10 years when we really think about mass adoption of those technologies. But shorter term a catalyst to keep an eye on is China. We've been talking about China in the commodity space for 20 years now. They've become the predominant consumer of many commodities, as they are the factory floor to the world in rising income levels. But with rising income levels you're now seeing that consumer economy develop in China. So that's not only stimulative for energy and industrial metals demand, but we're even seeing that in things like coffee, and cocoa and some of the soft smaller commodities where China's becoming a material consumer in places that they hadn't been involved historically. So I think whether it's technology or other catalysts, there's some important dynamics to keep in mind here. Gillian: So you've discussed industrial metals, and some of the tailwinds that we're facing there, talk to me a little bit about precious metals now as well. Kevin Baum: I think it's important to distinguish between industrial metals and precious metals because they are fundamentally different. When we think about precious metals, first and foremost, we're talking about gold. Now, unlike most other commodities in a broad basket portfolio, gold is neither used much in industrial applications nor is it consumed, it's thoughts of as a currency or safe haven asset. So we definitely think in the current risky geopolitical environment there is a place for gold. It's a little bit less than 10% of our portfolio. But if we have a rising rate environment because of surprises and inflation, that can be good for gold. But if it's simply a normalization of interest rates where real rates are rising, inflation stays relatively stable, but The Fed tightens, historically that's not been the best environment for gold. So gold is a little bit of an odd duck relative to the rest of the commodity universe. We actually would prefer silver in the precious metals space. Its valuations right now are very attractive relative to gold. And then of course if we look more broadly, we have platinum and palladium. And palladium's been a very strong performer, as China's vehicle purchases have sky rocketed, their gasoline consumption engines, and palladium as a catalytic converter has been in strong demand and had really strong price performance. Gillian: Now, this is interesting because very different drivers are impacting the precious metals, so you can't group them together. For gold it might be a safe haven, but for palladium it might be industrialization in China. Kevin Baum: That's exactly right. And China does have many different interesting dynamics going on. Again, we talk about rising income levels, the rise of the consumer class. So we've talked a little bit earlier about how that impacts some of the soft commodities, but it also impacts livestock. We're seeing livestock or meat consumption rise dramatically in China. So not only are people now eating and consuming more protein, so more cattle, more hogs, but that, by definition, increases demand for agriculture, because it typically takes about six pounds of agriculture to put one pound on an animal. So again, all of these demographic dynamics are very stimulative to commodity prices. Gillian: Excellent. So we've gotten a nice introduction to the opportunity set that each of you is working with. And now I want to move over to portfolio construction. So let's help advisors who are watching this program understand where your various products fit in and how they should think about real assets and structuring those investments broadly. So, Ryan, I'll kick off with you. How do you think about diversification within your fund, and then perhaps more broadly how should advisors think about it? Ryan Dobratz: Yeah, absolutely. So in terms of diversification of fund as a group that does a lot of work to know as much as we can about companies and securities, and the management teams that we’re investing alongside. We feel like we know just as much, if not more, than the broader market about our businesses, and the securities that we own. And so what we want to do is we want to concentrate our portfolio around our top ideas. Generally the top 10 positions in our fund account for about 45-50% of the assets. We usually hold about 30 securities in total, so it's a concentrated portfolio. But it's more prudently concentrated than it had been in the past. If you were to look at the fund sort of before the financial crisis you would have found us with 10-12% positions overweightings to certain property types, overweightings to certain countries. And we’ve put in limitations since then. So we are concentrated, but more prudently concentrated because we limit position sizes to 7% or less of the fund. We have limitations on property types, we don't have more than a third of the capital of the fund invested in any single property type. And we also don't have any country account for more than 25% of the fund’s capital outside of United States. So we think that provides a little bit of a diversification. But we do want to certainly concentrate around some of our top ideas, and that's paid off for us over the years. Gillian: [Inaudible] Kevin. Kevin Baum: Yeah, Gillian. It's almost the same story with USCI, our broad basket commodity fund. At any given time we have 14 commodities in the fund, 7% positioned, so they're equally weighted, we rebalance monthly. So similarly we think about being diversified within the basket. We think about the diversification benefits that brings a stock and bond investor. But we know that just a 5% allocation to commodities can increase portfolio returns significantly in a rising inflation, rising rate environment. And again, we know that rebalancing brings benefits. So whether you're investing in commodities or real estate with Ryan's product, when you combine those investments into a stock bond portfolio, you dampen the volatility of the aggregate portfolio, you increase the compounded returns over time, and you have inflation protection. So we think that again, combining commodities, real estate and other real assets makes perfect sense. Gillian: And what do you think advisors need to focus on when structuring a real assets allocation within a client's portfolio? Ryan Dobratz: I mean it seems like real assets serves as a true bedrock in most portfolios. What we're seeing is that most investors are replacing what had been just a real estate allocation, with a real asset allocation and generally dividing it between commodities, infrastructure as well as real estate. And also thinking more about how the different components and especially real estate will perform in a higher rate, in a higher inflationary environment. So when we talk to a lot of investors and advisors, etc, we want them to know that there is more to real estate than just REITs. And if they look at the Third Avenue Real Estate Value Fund, or look at other funds that have a flexible mandate that can invest in these other areas, to consider what value they can add in a higher rate, higher inflationary environment. And it certainly justifies an allocation, if not an outright replacement in most real estate allocations in portfolios. Gillian: And, Kevin, anything to add in terms of what advisors need to focus on when allocating here? Kevin Baum: Well, I think advisors, first and foremost, if they're concerned about rising inflation, rising rates, are probably going to allocate to real assets away from fixed income. And that's logical if rates are rising. But as Ryan was just mentioning, the correlation properties between the different asset classes within this real asset bucket are typically pretty low. So we do think it makes sense to diversify even within the real asset space, commodities, real estate, infrastructure, just as Ryan was mentioning. Gillian: And staying with you here, can you give us a sense of how your solutions fit into this broader allocation? What should advisors think about when deciding to allocate to your products and solutions? Kevin Baum: Sure. I think it's critically important to think about commodities, to do some analysis because it's not a homogenous asset class. When we look at the dispersion of index returns, think about US large cap equities, the S&P 500 versus one of the Russell Indices, may just have divergence of 2-3 basis points per annum. If we think about emerging market equities, they have a little bit more dispersion of returns, but it's still pretty low, 25 -50 basis points per annum. In the commodity space you can see 8-10% return differences year over year between the various commodity indices. So the benchmark that we manage our product against, the SummerHaven Commodity Index, again has outperformed most of the first generation indexes by 3-5% per annum. So we think not only do we need to have an analysis of what assets do we want to include in our portfolio, but specifically what products. And we think USCI is the right commodity product. Gillian: So instead of thinking about this passive vehicle as something that's market cap weighted, obviously there's an intelligent design that you've put into how you structure your product? Kevin Baum: That's exactly right, we're using a couple of different screens or filters to isolate on those commodities with the most favorable fundamentals and the strongest price returns. Gillian: Got it. Ryan, what about you? Ryan Dobratz: Well, you know, we think that ... would you mind repeating the question? Sorry. Gillian: Of course, sure. Ryan, when advisors are thinking about where your products and solutions fit in, give us a little bit of a sense of your competitive advantage in this space- Ryan Dobratz: Yeah. So in terms of how the Third Avenue Real Estate Value Fund fits in, we think that it is interesting in the sense that it offers investors an exposure to some of the best in class real estate companies, best in class portfolios, some of the best opportunities. Not only in the United States, but also in some of the great markets globally, whether it's London, Hong Kong, Singapore, Sidney, etc. So a global allocation, you know, is certainly additive to a portfolio. In terms of our competitive advantage, we really have two, one, we've talked about, it's our flexible mandate that allows us to invest in REITs and operating companies in these real estate related businesses. And two, we have found likeminded investors who share our long term view and allow us to buy into these businesses or countries, or property types that are out of favor, and on average hold them for 4-5 years until conditions improve and security prices rebound. Having that long term view is certainly unique in this space, and has added a lot of value. If you look at our returns, you know, over the 20 years of the fund you'll find that we have been able to outperform in almost every time period, and we think it's really a result of having this flexible mandate, and having a long term view that our investors fortunately grant us with. Gillian: So you're diversifying not only the types of real estate you invest in, but also geographically as well? Ryan Dobratz: Yeah, absolutely Gillian: So we've come to the end of our discussion and I really want to give you each an opportunity to give us just some closing thoughts, whether it's about real assets broadly, the macro environment or even how you fit into that universe. So I'm going to start with you, tell us a little bit about what advisors should take away from watching this masterclass here today? Kevin Baum: Well, we've talked a lot about rising inflation, we've talked about rising rates, so it's a very timely discussion. We think it's absolutely critical that if advisors and investors haven't been allocating to real assets, that they consider it and begin to do that now. But I would also like to make sure I emphasize that real assets should be part of a long term strategic portfolio. They're great diversifiers, with low correlation to stocks and bonds, they have strong return potential. So again, we think this is a discussion we should always be having, but it's extremely timely right now. Gillian: So we have the benefit of the macro environment, supports investing in real assets, but there should be a perennial allocation anyway. Ryan. Ryan Dobratz: ] No. I would just reiterate that if rates are going up for the right reason, it's actually quite good for real estate, as we said, both on the commercial side, and the residential side. But you need to make sure that you have a real estate allocation, or real estate portfolio that can get exposure to the areas that are going to do quite well. And that isn't the case for a lot traditional real estate allocations that are strictly focused on REITs and that advisors certainly consider adding some of the other elements of real estate and property to the portfolio to benefit looking out over the next 3-5 years. Gillian: So often we think about rising rates with a groan, but in the real estate market it's actually a tailwind. Ryan Dobratz: This could be the case. Gillian: Excellent. Well, thank you both so much for joining us here today. I feel like we got a nice sense of the macro environment, the opportunities you're focused on, and thanks for educating our advisors on real assets. And thank you for tuning in. From our studios in New York, I'm Gillian Kemmerer and this was the Real Assets Masterclass.