The Paired Trade

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Like moMANon, I’m a little nervous about the market right now.  Not nervous enough to sell everything and dig out the bomb shelter, but nervous enough to add some defensive positions to my personal portfolio.  My current allocation is approx. 65% long equities, 25% cash, and 10% “defensive” positions in a volatility ETF and some gold mining and silver equities.  Yes, 0% in bonds, which moMANon would hate but I just can’t get comfortable with the limited upside, potentially severe downside nature of bonds in today’s environment.  I’ve decided to move up my defensive allocation by short selling a REIT to offset a long position I have in another REIT.

Tomorrow I’m pulling the trigger on a short sell of Regency Centers Corporation (REG), which is a company that owns and operates retail shopping centers throughout the country and is structured as a Real Estate Investment Trust (REIT).  A few weeks ago I generally laid out my arguments of why I’m interested in shorting retail-focused REIT’s: https://atginvestments.com/2014/06/12/speaking-of-summer-shorts/

Since that post, Regency has announced an unsolicited offer to buy a smaller retail REIT called AmREIT, Inc., (AMRE) out of Houston, TX at $22 per share, which is a 20% premium to their current share price, $2 psf premium to their all-time high share price, and a 4% premium to their net asset value (essentially value of their real estate and other assets less liabilities).  While there may be some SG&A (corporate overhead cost) synergies from a merger, this acquisition would still likely be dilutive from a combined earnings per share and P/E standpoint for Regency.  In my opinion Regency has offered to buy a bunch of retail centers at a price above their fair market value for a product type that I personally feel is already getting overvalued.

My offsetting “pair” to this trade is a long position in HCP, Inc. (HCP), which is a REIT that owns and operates healthcare-related real estate (senior housing, medical and assisted living facilities).   While this isn’t a perfect market-neutral trade with REG, I think it will protect me from substantial losses on REG if future gains in the overall market are driven by easy money and low interest rates.  HCP offers  a current dividend of 5.3% vs. 3.4% for REG, which means that I’ll make a 1.9% annual return if the two stocks move positively in tandem.

Email me/ leave a comment  if you’d like to go into deeper analysis and rationale for this trade, but the following table lays out the main reasons for why I’m longing this healthcare-related REIT and shorting a retail-related REIT:

Paired Trade Graphic

 

As compared to Regency, HCP offers a better dividend with a lower payout ratio and cheaper P/E valuation, not to mention a product type (healthcare-related real estate) I’m much more bullish on than retail real estate.  The only clear advantage that Regency has over HCP I can ascertain is that consensus earnings growth over the next 5 years is higher than for HCP (5.9% vs. 3.0%).  Regency doesn’t have an overly impressive track record of earnings growth over the past 5 years (7.9%) and I think the moat-like qualities of grocery anchored real estate are fading quickly. In contract  HCP has grown earnings 31% annually over the past 5 years and has increased their dividend every single year since their IPO in 1985.  Maybe the analysts are right and REG outperforms HCP over the next several years, but I’m comfortable going against the grain on this bet.

 

 

 

 

 

 

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One thought on “The Paired Trade

  1. Thanks for the comment and thoughts John. With regards to covered calls, I haven’t played in that arena but I do think now is a great time to consider that strategy- it just feels like the likelihood of leaving big stock gains on the table right now is pretty remote, and if the market wiggles around the mean or slowly drifts up its a great way to boost yield. My only heartache with it in this environment is that its tough to gut check whether you are selling away your upside for a fair risk-adjusted option price unless you have a masters in statistical finance (i definitely don’t, but your wife does ;). I guess if you are primarily concerned with meeting a set absolute return, that does not matter so much.

    With regards to your second question on royalty trusts, that’s definitely a security type that violates my own KISS (Keep is Simple, Stupid) principal. While the yield is great you are dealing with a finite cash flow source (like buying property on a ground lease) and likely riskier wells under the logic that the oil guys weren’t able to line up cheaper costs of capital for it. I don’t doubt that our insatiable demand for fossil fuels could very well make this a great investment play, but personally I just don’t know enough about it to play ball and feel ok with it.

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