A Trend That Will Run to the End of Humanity

Editor's note: Today, we're continuing our Digest holiday series with more actionable research from Dr. David Eifrig. But today's issue isn't from his Retirement Millionaire advisory...

Instead, it comes from Income Intelligence. This is Doc's income-focused service designed to help everyday investors find the biggest, safest income streams in the market... using many of the same techniques he learned during his career on Wall Street.

In Income Intelligence, Doc shows readers how to profit from every income sector, including dividend stocks, MLPs, REITs, BDCs, utilities, preferred shares, municipal bonds, Treasury bonds, and more. And every month, Doc delivers a new issue with a breakdown on what's happening in the income markets... and where investors can find the biggest, safest yields right now.

In today's issue, originally published in November, Doc explains how investors can lock in stable income from one of the biggest, most important trends in the world today...

A Trend That Will Run to the End of Humanity

By Dr. David "Doc" Eifrig, editor, Income Intelligence

"You can find good reasons to scuttle your equities in every morning paper and on every broadcast of the nightly news."

So said legendary investor Peter Lynch, who managed the best-performing mutual fund in the world.

Lynch had a short but very successful 14-year Wall Street career. But he's usually forgotten as one of the great thinkers of the market. Part of that is due to his lack of "doom and gloom" leanings. In his own words, Lynch was the "Will Rogers of equities, the man who never saw a stock he didn't like."

That attitude led Lynch's Fidelity Magellan Fund to return 29% a year from 1977 to 1990... more than doubling the performance of the S&P 500.

Many serious investors tend to scorn those who run their portfolios with Lynch's brand of optimism. But optimism has been the most successful strategy for long-term success.

Lynch's fund succeeded through two recessions in 1980 and 1981, the astronomical Volcker's interest rates of 20%, and the Black Monday crash of 1987.

Read that list again if you're considering getting out of your investments today.

The simple truth is that markets and economies are strong, resilient institutions... And since businesses tend to grow, so do financial assets.

Skepticism is healthy. Unbridled optimism can drive you to long-shot growth companies with sky-high valuations or lead you to concentrate too much wealth in an investment that you believe to be a sure thing.

But an unshakeable sense of impending doom doesn't serve anyone well.

Today, we're going to look at a trend that we expect will see rapid, even exponential growth from now until the collapse of human civilization. And we have a simple, stable way to invest in it and begin generating a 4% yield today…

But first, let's look at some of the most common "existential threats" to the market that investors are scared about...

How to Prepare for Any Sort of Market

Right now, we aren't particularly worried about threats to the market. As Lynch said, at any time, you can find a number of bearish indicators to argue the case for a collapse. Today, we can find just as many bullish ones...

For example, rather than an earnings recession, we have earnings growth. As of early November, the earnings for the S&P 500 are up 2.9% over last year.

Folks also love to focus on the amount of debt in the system. After all, as you can see in this chart, it has climbed almost nonstop...

But is it fair to compare the total stock of outstanding debt from 1960 to the numbers today? Of course not. The world is much bigger now. It's inevitable that the level of debt would expand.

That's why you should always compare debt with assets, as you can see in the chart below...

On this measure, it appears the lessons of the financial crisis have been learned. The deleveraging continues, despite historically low interest rates.

Rather than try and weigh the evidence of one potential future against each other, we prepare for both.

Here at Income Intelligence, my team and I focus on profitable businesses with productive assets. We take reasonable position sizes. We hold multiple asset classes intentionally – things like stocks and bonds, preferreds, munis, and international dividend payers. If an asset returns steady income with a margin of safety, it will serve us well as investors.

You should shy away from predictions. And when folks make them, if you're a follower, they'd better be airtight like the one we're taking advantage of today.

Lots of folks claim to have found an "unstoppable" trend. It's usually hyperbole.

Not long ago, folks considered "Peak Oil" and prices north of $250 a barrel an inevitability. That was a bust.

Other trends are legitimate, but have a limited time horizon. For instance, demographic shifts will undoubtedly drive health care spending higher, but after a few decades, the effects will peter out.

Today's trend, though, is truly unstoppable...

Only One Direction: Up

Mankind will constantly create and store more data.

The sheer amount of data that exists, and how fast it's growing, boggles the mind. More information has been created in the past two years than in the prior 6,000-some years of human history.

That means everything from the scribblings of Socrates, to printings of the Gutenberg Bible, to the design files for the original Apple iPhone... doesn't stack up against the medical records, Tweets, and computer files we've created in just the past 24 months.

According to consulting firm IDC, the amount of data stored and created will grow 40% a year through the next decade...

If you've ever looked at the results of compound growth with just 5% or 10% growth, you can see our data-storage needs will grow at a remarkable pace. At this rate, the amount of data is doubling every two years.

By 2020, total data stored and created will reach 44 trillion gigabytes (also known as 44 zettabytes). If you can imagine a gigabyte as a single brick, the 13,000-mile-long Great Wall of China is like a zettabyte.

Much has been made of the promise of "Big Data"... about how we'll be able to apply deep-analysis techniques to become more efficient and gain new insights. We're skeptical. More information doesn't always mean better answers.

But we're not interested in the analytics. We're interested in the hoarding nature of humans and the storage and retrieval of data... the basic read-and-write functions that happen trillions of times a second.

Real Estate for Virtual Tenants

As the amount of data gets bigger and customers demand faster access, the business of Digital Realty Trust (DLR) will grow.

Digital Realty is a real estate investment trust (REIT). The laws only allow certain business types to use the tax advantages that come with this trust structure... those companies that can be described as renting out assets.

Digital Realty and several other "digital REITs" aren't typical technology companies. They have a lot of parallels with apartment or commercial properties.

The business works like this...

Digital Realty builds a data center. These may often look like simple warehouses, but they are complex affairs. They require souped-up power-management systems, extensive cooling systems, impenetrable security, and highly specialized connections to the Internet.

Once these are built, Digital Realty "rents out" server space to businesses. This process can take several forms, which we'll get into a little later on.

In the basic framework, it doesn't make sense for most businesses to build their own data centers.

A small business may have databases of customer information or an inventory system for its products. It doesn't want to go and find a rare, expensive expert on the interlocking parts of the hardware and software it takes to maintain that system. It especially doesn't want the expense of permitting and building a tiny facility. So it farms the job out to Digital Realty. Inside a Digital Realty facility, that small business will have a handful of servers to run its data needs.

Large companies see some of the same benefits. It's easier and cheaper to host your data inside a ready-built data center than it is to build your own. That's why Digital Realty even boasts massive, tech-savvy companies like Facebook and Amazon as clients.

You can imagine Digital Realty as an apartment building. Digital Realty owns the assets. Small portions get rented out to tenants. Digital Realty, as the landlord, has to do some maintenance and upgrades from time to time. Meanwhile, the tenants get locked into leases with regular rate increases.

It's the specifics of the arrangement that make Digital Realty such a great business. Digital Realty is the king of data centers. It's by far the largest data-center provider in the business. It currently owns 139 data centers spread across North America, Europe, Australia, and Asia. It totals more than 25 million square feet of data-center space – equivalent to more than 400 football fields.

This spread is important. Customers can build redundant databases in multiple locations to protect against data loss in the case of catastrophe. Signing on with Digital Realty means a client can have data backups in Atlanta, Seattle, and Singapore without crossing providers.

The bulk of Digital Realty's business comes from what's known as "wholesale" data centers. These are the big, complex customers who have specific needs.

In the wholesale business, a customer will rent multiple racks of servers. They'll work with Digital Realty engineers to design the infrastructure and make sure it suits the customer's needs. They may even have full-time employees who work at the data center in concert with Digital Realty.

In this vein, Digital Realty boasts big-name customers such as IBM, Facebook, AT&T, and Oracle.

The partnership with IBM is worth investigating, both as an example of Digital Realty's services and an examination of its biggest customer.

You've likely heard of cloud computing. This is a service that customers can plug into to get quick and cheap computing. Amazon offers Amazon Web Services, Microsoft sells Azure, and IBM provides a product called SoftLayer.

A cloud-computing service is essentially a port into a data center. When IBM started SoftLayer, it used Digital Realty rather than building its own data centers. IBM owns data centers of its own, but it can deploy resources through Digital Realty with more speed and flexibility. And since Digital Realty has so much buying power for everything from hard drives to power-supply infrastructure, it's able to build those resources at a better price.

As of the latest report, IBM has servers in 23 of Digital Realty's locations, occupying 873,000 square feet and accounting for $109 million in annual rent.

If you need evidence of Digital Realty's expertise, one of the most efficient and skilled data-center operators in the world is Amazon... Despite that, it rents $12 million worth of server space per year from Digital Realty.

About 77% of Digital Realty's revenue comes from this wholesale division.

Another 14% comes from what's known as colocation. This simply means using servers "also located" in a data center with other servers, rather than building your own. This business segment represents smaller "plug and play" customers that need a standard server setup. They can simply sign up and get some servers running.

Digital Realty doesn't report separate numbers for these two groups – though we think they are very distinct businesses. So we're using JPMorgan's published estimates of the revenue breakdown.

The last 10% chunk of Digital Realty's revenues comes from what's called interconnection. Digital Realty offers special connections between data centers, allowing customers to provide better connections to their own customers for an additional fee. Most data-center providers offer a service like this, but it particularly benefits the larger providers like Digital Realty. When you have more servers around the globe, it's more advantageous to establish connections between them. That's how Digital Realty brings in nearly $40 million in annual revenue from interconnection.

If you're looking for a business that promises rapid growth, you should look into colocation services. At Digital Realty and its competitors, colocation is outpacing the wholesale market.

Some of its competitors focus on colocation over wholesale. So why have we picked Digital Realty, which focuses on wholesale?

Wholesale isn't growing as fast. But growth isn't everything. The wholesale business has its own advantages.

First, wholesale customers come with long-term contracts.

While the typical colocation contract lasts two to three years, wholesale contracts can last five to 10 years. Only 2.7% of Digital Realty's rent comes in on a month-to-month basis. Meanwhile, more than 38% of rents are contracted through 2020, including annual rent increases.

The average signed lease for Digital Realty lasts 11 years. The average lease on the books is more than five years.

You can't get those sorts of contracts with colocation services. As investors looking for steady income, we'll take the stability afforded by long-term contracts over the potential for growth when it creates less predictable revenue swings.

Second, those contracts may not even be the strongest draw for customers to stay with Digital Realty. Once you've built a custom data solution and you have your entire system built around it, switching becomes a major hassle. The average customer would have to spend $10 million to $20 million. Possibly much more.

So while some competitors post better growth, they have higher valuations and lower yields to go with it. Given the uncertainty of that growth, we'll expect more volatility in their fundamentals and share prices as well. Remember though, it's not that they are better managed... it's that they focus on a different type of product.

A Simple Case of Fundamentals

Over the last 12 months, Digital Realty has crossed the $2 billion mark in revenue, doubling in the last year. Adjusted funds from operations (a key measure of REIT profitability) has come along with it, rising from $4.09 per share to $5.65.

This has driven distributions from $2.72 to $3.50 per share since 2011. That puts Digital Realty's yield at just under 4% looking forward. It has raised its payout each year for the last 11 years.

We'll investigate more of Digital Realty's fundamentals in the Income Drilldown section of this issue.

As far as valuation goes, Digital Realty trades right in line with the average digital REIT at 17.2 times enterprise value (EV) to earnings before interest, taxes, depreciation, and amortization (EBITDA), a comprehensive valuation measure.

With a price that is 15.9 times its funds from operations, it's about 10% cheaper than the digital REIT universe.

We've been watching Digital Realty for some time now. In the wake of Trump's election win, technology stocks have sunk a bit. Assigning cause and effect to market moves is always a matter of guesswork, but Trump's immigration policies may reduce the flow of highly-skilled labor that the technology industry needs.

Whatever the reason, we know that data needs will grow. It's an unstoppable trend. The recent dip in tech stocks gives us an opportunity to buy in cheaper than we would have a few months ago.

Rather than pick an unprofitable tech company with an uncertain future, we can lock in a stable cash flow from a digital REIT that dominates the industry. That's an investment that Peter Lynch would certainly like.

Action to take: Buy Digital Realty Trust (DLR) up to $95. We'll use a 20% hard stop to protect our capital. I recommend putting no more than 4%-5% of your portfolio in any single position.

Here's to our health, wealth, and a great retirement,

Dr. David Eifrig Jr., MD, MBA

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