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Summary

• Several hedge funds have long positions in the trust even though short interest is fairly high.
• Trust is undervalued even after acquisition and secondary offering.
• Company is growing both organically and through acquisition.

By Andrew Sebastian

Digital Realty Trust (NYSE:DLR) is a real estate investment trust focused on the technology industry with datacenters throughout the world. The trust recently doubled in size with its acquisition of Telx that expands its presence in the colocation business in the U.S. and is expected to increase earnings in the first year of combination. DLR rose on the Telx news suggesting that its shareholders were happy with the deal. A number of hedge funds were shareholders of DLR as of their latest filings with Osterweis Capital holding the largest stake of over 1 million shares with a value of $68 million. Forward Management and Arrowstreet Capital also had holdings in DLR with 330,000 shares and 172,000 shares, respectively. Quant-focused firms D. E. Shaw, Citadel and Renaissance Technologies were among the top holders of DLR as well. Two funds entered into new positions in DLR, while five exited their stakes. Some fund were presumably short DLR as well as the stock had a 12% short interest as a percentage of its float.

We find it beneficial to track hedge funds like Osterweis and Arrowstreet because their stock picks historically managed to generate alpha even though the filings are up to 45 days delayed (see more details here). We used a 60-day delay in our back tests to be on the safe side and our research showed that the 15 most popular small-cap stocks among hedge funds outperformed the S&P 500 Total Return Index by an average of 95 basis points per month between 1999 and 2012. After adjusting for risk, our calculations revealed that these stocks' monthly alpha was 80 basis points. We also have been sharing and tracking the performance of these stocks since the end of August 2012, during which time they have returned 142%, outperforming the S&P 500 ETF by nearly 84 percentage points. With that in mind, let's take a closer look at DLR to see if the funds that are long will prevail or if investors should take a cue from the shorts and avoid the stock.

Funds from operations (FFO) grew 9% from 2013 to 2014 for DLR and have been growing for the last five years as companies take advantage of its colocation services for datacenters. FFO also has grown on a trailing twelve months basis with the first quarter of 2015 included with FFO of $744.2 million. With the addition of 10.5 million shares through a secondary offering to fund its purchase of Telx, the diluted FFO per share on a trailing basis is $5.08. At DLR's current market price, DLR's P/FFO multiple is low at 13.3. REITs on average trade at P/FFO multiples of 17. Thus, DLR seems to carry an extremely low valuation for a company in an expanding industry and one that's growing its power through its recent purchase. Moreover, DLR already offers a 5% yield, which will likely increase as the company grows organically and expands through acquisition.

DLR makes for a great real estate play in the growing market for cloud services and the need for datacenters and space to support those services. Companies are turning more to colocation REITs like DLR because the capital needed to build or expand their own datacenters is vast and doing so does not expand their asset base. DLR has done a great job of increasing revenues and its resultant cash flows, and the Telx acquisition strengthens its business in the U.S. DLR also has growing operations overseas that add an element of diversification to its revenue, so it is not totally dependent on the U.S. The trust generated close to $400 million in revenue from overseas and $1.2 billion from the U.S. in 2014 compared to about $94 million overseas and $772 million in the U.S. in 2010. The strong performance of the company and its relatively low valuation make it a great buy right now. Thus, it is best to be with the longs like Osterweis in this instance and not with the shorts in DLR.