My Two Portfolio Picks for a Recession - Keppel DC REIT (AJBU) & NetLink Trust (CJLU)

As I write this, the Dow Jones Index has fallen about 800 points in light of a negative indicator from the bond markets - apparently, the yield curve between the 2-year and 10-year bonds has inverted for the first time since 2007, thus triggering a recession warning. This led to a sell-off in stocks as investors moved into bonds and gold, nullifying the Trump administration's decision to hold off on applying more tariffs on Chinese goods. I expect to see a mirrored effect take place in Singapore markets over the next few days as investors move to safer assets due to short-term fear.

(Above) President Trump laying blame on the Federal Reserve for the yield curve inversion.

Recession-worries are nothing new. In fact, murmurs of recession have been present for many months, and people have been bracing for hard times. Friends and acquaintances have been cutting back on spending, and making less risky investments. It is undeniable that Singapore's position as a port city leaves it vulnerable to collateral damage from global events. Recent events in the Asian region threaten to inflict greater volatility on our markets: an economic slowdown affecting China, a trade dispute between South Korea and Japan, no signs of the US-China trade war abating, ongoing protests in Hong Kong, and escalating tensions between India and Pakistan. All signs point towards a slowdown in global growth.

I have received questions from young investors and old friends alike on investment opinions for "slow-growth/recession periods" that can still return a decent yield. Having defensive counters in any portfolio is always a decent option for diversification. With the current slow-growth environment in mind, I want to highlight a few things that I look out for when analyzing picks:

(1) Exposure to trade
(2) Resilience of business
(3) Exposure to foreign currency risk
(4) Exposure to interest rate risk
(5) Dividend yield
(6) Possible plans that would bolster business

I just wanted to share my views on a couple of defensive picks that I feel have resilient fundamentals and have been paying decent dividends.

(1) Keppel DC REIT (AJBU)

Data centres are largely untouched by the trade war, and remain a crucial component for business operation and continuity in any market climate. In fact, as the world moves towards greater digitization, increased demand for data becomes essential across all sectors of business, from fast-moving consumer goods (FMCG) companies to financial service corporations. Even in an economic slowdown, data usage (driven by insights, analytics, media consumption, etc) is still an essential part of business. Data needs to be housed, and more companies are turning to data centres as they seek greater access to cloud capabilities and connectivity. Analysts have predicted robust growth for the data centre industry worldwide. Citing multiple predictions:

American real-estate management firm Jones Lang LaSalle (JLL) predicts that demand for data centres in America will double by 2021.

DBS mentions that demand in Hong Kong is set to increase at 15% per annum, possibly entering a supply shortage by 2021 due to lack of available land space for new construction.

OCBC Investment Research indicates that demand for data centres in Singapore should grow by about 40% by 2022, as demonstrated in the chart below:

(Above) Data Centre Demand, Supply, and Utilization in Singapore

Keppel DC REIT manages 16 holdings throughout Asian, Australia, and Europe, with one holding in Australia expected to be completed in 2020. With the rise of 5G technology, and with global demand for cloud technology steadily increasing, data centres stand to benefit. With all that has been said, Keppel DC is poised to be a defensive pick during troubled times - data is essential regardless of bull or bear market, and the accompanying storage for the necessary systems also reaps the same benefit. 

Keppel DC's distribution-per-unit (DPU) has been increasing since 2017, last stopping at 7.6 cents a year. The REIT's books also look decent, as borrowings stand at 31.9% of assets, giving it room to acquire and expand if necessary. The REIT's portfolio of data centres has 93.2% occupancy, and has a weighted-average lease expiry (WALE) of 7.8 years (among the longest in the S-REITS market). Ability to account for interest expense is healthy, with an Interest Coverage Ratio of 12.9. 

Regarding fluctuations in interest rates and foreign currency, the REIT has hedged 80% of their loan book with floating-to-fixed interest rate swaps, with forward contracts and natural hedging serving to mitigate fluctuations in the foreign currency market. 

Keppel DC REIT last traded at $1.70 on Wednesday (14th August). 

(2) NetLink NBN Trust (CJLU)

In determining business resilience, I generally consider monopolies a big bonus, especially if the product/service offered is essential and has the potential to be boosted by government plans. 

NetLink NBN Trust has not seen much growth in price since its IPO, but management aims to pay out 100% of Cash Available For Distribution, which has resulted in a DPU of 4.88 cents for FY2019. 

DPU aside, the main thing that drew me to this Trust was NetLink's core business, which is operation and development of the fibre network infrastructure of the Singapore government's Nationwide Broadband Network (NBN). Currently, NetLink stands as a monopoly, as it is the sole provider of fibre broadband services for roughly 1.3 million residences in Singapore. There was minor concern that newcomer SPTel (a collaboration between ST Engineering and Singapore Power) would eat away at NetLink's market share, since SPTel's stated goal was to provide an alternative fibre network for Singapore. However, SPTel will compete with NetLink only for clients in the business and government sectors, leaving NetLink dominant in the residential market. It is unlikely that SPTel will venture into residential broadband, since the infrastructure has already been laid by NetLink, and costs to develop an alternative would be exceedingly high. 

Due to the nature of NetLink's business, the majority of NetLink's revenue is recurring. Prices are regulated by the Infocomm Media Development Authority of Singapore (IMDA). Under the Regulatory Asset Base (RAB) Pricing Framework, NetLink earns revenue by obtaining a certain return on capital expenditure. This rate of return has been set at 7% by the IMDA, allowing NetLink to get a 7% return on capex investments. Currently, almost 80% of NetLink's revenue is obtained under the RAB Pricing Framework, thus implying a recurring and regulated stream of revenue. Furthermore, an additonal 10.5% of revenue (from Co-Location and Central Office) is also recurring instead of one-off, thus giving NetLink a grand total of 89.9% recurring revenue out of all its businesses. 

Additionally, it has been mentioned that the rate of return stipulated by the IMDA is revised once every five years, so provided nothing unforeseen occurs, returns from the RAB segment will be constant until 2022. Even if SPTel does eat into NetLink's non-residential connections revenue, the segment only comprises 8.3% of NetLink's total revenue. Analysts consider this unlikely, as NetLink and SPTel favour different groups of corporate clients.

(Above) Breakdown of NetLink's Revenue Streams.
Source: NetLink NBN Q1 FY20 Presentation

Even in a recession, it is nigh impossible that households and corporations would choose to cut broadband services as a means to save costs. With the Smart Nation initiative ongoing, NetLink still stands to benefit as the prime provider of fibre network services to the island. As new housing developments come to fruition, NetLink also stands to gain additional revenue through installation and recurring connections. Further growth is expected, as NetLink is monitoring 5G development, and stands ready to provide infrastructural support.

Being that its operations are limited to Singapore, NetLink has little exposure to currency fluctuations. NetLink is also relatively unaffected by global trade headwinds, since it operates in an uncorrelated industry. 100% of NetLink's existing bank loans have been hedged against interest rate risk - in the same manner as Keppel DC REIT, NetLink also uses interest rate swaps to mitigate risk.

NetLink NBN Trust last traded at $0.89 on Wednesday (14th August).


I wish you guys all the best during these times. 

Until next time.


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